A Question of Size

If there is safety in numbers and comfort in size, fund investors are now putting their need for reassurance on parade. The growth-stock fund companies that raked in the bulk of new dollars in the late 1990s (Janus, Putnam Investments and Alliance, for instance) have given way to a new crop whose single most obvious characteristic is their hugeness. During the first five months of 2004, funds recorded

If there is safety in numbers and comfort in size, fund investors are now putting their need for reassurance on parade.

The growth-stock fund companies that raked in the bulk of new dollars in the late 1990s (Janus, Putnam Investments and Alliance, for instance) have given way to a new crop whose single most obvious characteristic is their hugeness.

During the first five months of 2004, funds recorded inflows of $133 billion, according to Financial Research Corp. Of the total, more than $106 billion went to just five companies: American Funds, Dodge & Cox, Fidelity Investments, T. Rowe Price and Vanguard Group.

The winning companies have earned investors' ardor. All of them avoid trendy offerings, charge low fees and rely on proven portfolio managers. But the concentration of dollars into their huge funds begs one important question: Have they gotten too big?

The Green Tide

The amount of in-flowing funds is impressive. In the past year, Growth Fund of America, the flagship growth fund from American Funds, grew to $77.9 billion from $46.2 billion in assets, passing Fidelity Magellan to rank as the largest actively managed fund. Washington Mutual Investors, a popular large-value choice from American Funds, grew to $67.6 billion from $51.3 billion in the same period. Meanwhile, Fidelity Diversified International swelled to $17.1 billion from $8.6 billion.

The size increases confer some obvious advantages, not the least of which is the ability to market more successfully, but no portfolio manager would argue that managing the larger funds is an easy task. In a tiny fund, a manager can limit his buys to the very best of his ideas. But after more assets arrive, the fund skipper inevitably must make less rock-solid purchases in order to absorb all the money. Another drawback of size: trading large quantities of shares can touch off unintended price fluctuations in the markets. This, in part, explains why many managers have delivered strong results with small portfolios — and then produced mediocre returns after their funds ballooned.

Over the years, researchers have attempted to quantify the impact of increasing assets on fund returns. The results of the studies have been mixed. Some giant funds do deliver above-average results, probably because of their relatively low fees. But giants rarely appear in the top ranks of the performance standings. And in all too many cases, small funds that start with a hot streak slow down as they gain more assets. The most notable example is Fidelity Magellan, which soared when Peter Lynch managed a small pool. In the last decade, with assets passing the $30 billion mark, Magellan has lagged the S&P 500 by more than a percentage point annually.

Some advisors remain confident that the giants can handle their new assets. Ken Richard, who began putting clients' money into American Funds in 1971, says he sees no reason for concern and continues keeping clients invested in funds like Growth Fund of America.

“American is like a great battleship that keeps steaming along,” says Richard, who is president of Kara Financial Services, a registered investment advisor in St. Paul, Minn. “I have never had a client complain about American Funds.”

It's true that many large funds are stable. When funds grow large, they also tend to become more diverse and less volatile, and for a cautious client, a giant fund can provide protection against blowups.

But investors who crave the highest performance may not find it in a huge fund where it is hard for the manager to place sizable bets on any one stock. Small-cap funds often become unwieldy when they approach $2 billion in assets, says Roseanne Pane, mutual fund strategist for Standard & Poor's. Mid-cap portfolios face problems when they pass $8 billion, she says. Large-cap funds have trouble managing more than $30 billion, says Russel Kinnel, director of fund analysis for Morningstar.

“Growth Fund of America is a good fund, but you can no longer think of it as one of the best growth funds,” he says. “The fund has gotten so big that it is hard to see how the efforts of the managers won't be watered down.”

Smaller is Better?

Though there is a case for sticking with current holdings in giant funds, this is surely a time when advisors should consider diversifying outside the biggest complexes. By considering less well-known companies, advisors can find funds with compelling track records and relatively small portfolios.

Kinnel cites American Century as an overlooked manager with a clean record and some strong offerings. Investors seeking a svelte large-value fund might consider American Century Capital Value, a no-load offering with $175 million in assets, or its load sibling American Century Large Company Value. During the past five years, Capital Value has outdone 87 percent of its competitors, including giant Washington Mutual. The fund has achieved its strong record with a low-turnover style that focuses on blue-chips. Current holdings include familiar names, such as ExxonMobil, Merck and Citigroup. Portfolio managers Charles Ritter and Mark Mallon look for strong companies that face temporary difficulties.

“We try to buy before the company starts fixing the problems,” says Ritter. “If you wait until there are signs of improvement, the stock will have already jumped.”

Some top funds remain limited in size because the managers primarily serve institutions. Such shops focus on maintaining consistent strategies, not on marketing to retail investors. A strong institutional player is Institutional Capital Corp., which oversees $13 billion, including $1 billion in ICAP Equity, a value fund that has delivered above-average returns in the past five years, while taking only mild risks. Portfolio manager Rob Lyon buys giant stocks that are selling at discounts to their industry peers.

Another fund with institutional roots is Julius Baer International Equity, which has $3 billion in assets and is managed by a unit of Julius Baer Group, the Swiss banking giant. During the past five years, the fund has used an idiosyncratic style to best 99 percent of its competitors. Portfolio managers Rudolph-Riad Younes and Richard Pell dart around the world in search of unloved stocks, buying Hungarian banks one year and Japanese electronics producers the next. The fund racked up big gains several years ago by emphasizing Eastern European countries that stood to benefit from being admitted to the European Union. To limit risks, the managers often hold some blue-chips.

“We don't want to track the benchmarks, but as an insurance policy, we are careful to stay diversified,” says Younes.

To find funds that are likely to remain small, try shopping at money management boutiques. Such independent firms lack the marketing muscle to become giants. Investors seeking a large-growth choice should consider Jensen Fund, run by Jensen Investment Management. During the past five years, the fund has outdone 98 percent of its competitors, including Growth Fund of America. Jensen only buys big stocks that have produced returns on equity of at least 15 percent for 10 consecutive years.

“To have that kind of record, a company must have a powerful competitive advantage,” says Robert Millen, a Jensen portfolio manager.

The Jensen managers buy shares when they sell at 40 percent discounts to what they consider to be fair value. That helped the fund avoid trouble in the 1990s and maintain tame risk scores.

One way to avoid bloated portfolios is to search for subadvised funds with several managers. In these strategies, the fund company hires outside stars to run the money. That way, no one manager becomes overwhelmed. And if a manager does stumble, he can be easily replaced with another freelancer.

Masters Select International has hired five top managers and given each one 20 percent of the assets. As an additional safeguard, the fund has announced that it will close when assets reach $1 billion.

“If we reach the limit, each manager will only be managing $200 million, and that is small potatoes in the fund world,” says Josh Weiss, research director of Litman/Gregory Fund Advisors, which manages the fund.

When Smaller is Better

When funds become flooded with assets, their returns often suffer. These top choices are still small enough to maneuver nimbly and outperform most of their peers.

Fund Ticker Category Assets $ millions One-year Return Three-year Return Five-year Return Max. Front-End Load % Rank in Category
American Century Large Company Value A ALAVX Large value $117 20.6% 4.2% NA 5.75% NA%
ICAP Equity ICAEX Large value 1,029 19.6 0.3 1.6 0 39
Jensen JENSX Large growth 2,156 16.5 4.4 6.7 0 2
Julius Baer International Equity BJBIX Foreign large blend 3,000 30.3 9.4 9.8 0 1
Masters Select International MSILX Foreign large blend 932 25.2 4.1 6.0 0 6
Source: Morningstar. Returns through 6/30/04.
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