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Is Your Mutual Fund Bloated and Should You Care?

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Asset bloat in a mutual fund is akin to the situation we’ve all found ourselves in while dining out.  Our meal is fantastic and we can’t stop eating it even though we know we’ll feel lousy and bloated if we don’t stop.  Mutual fund asset bloat can also be a big problem for investors.

What is asset bloat? 

Asset bloat is simply a large increase in the assets managed by a given mutual fund.  Asset bloat is typically not an issue for index funds or money market funds, but it certainly can be for actively managed stock and bond mutual funds.

Asset bloat can be caused by an influx of new money into a mutual fund, often the result of a period of superior performance by the fund.  It has been my experience over the years that investor money chases good performance.  Asset bloat can also be organic in nature via the fund’s investment gains.

Morningstar’s Russ Kinnel wrote an excellent piece on mutual fund bloat that you should check out.

Why is asset bloat a problem? 

At some point an actively managed mutual fund can become too large for the manager(s) to effectively manage.  As an example, Peter Lynch was the legendary manager of the Fidelity Magellan Fund (FMAGX).  Lynch managed the fund from 1977 until 1990 during which time the fund’s assets grew from about $18 million to about $13 billion.  During this time period the fund’s average annual return was 29%.

At the end of the decade of the 1990s the fund’s assets had hit $100 billion, ultimately dropping to today’s level of about $16 billion.  Subsequent to Lunch’s departure the fund’s performance never hit the levels seen during Lynch’s tenure.  I have to believe that this was in part due to the massive growth in the fund’s assets.

This phenomenon is especially problematic in mutual funds that invest in small and mid-cap stocks.  Due to the smaller market capitalization of the underlying holdings in these funds at some point it becomes difficult for the manager to find enough good stock ideas within the fund’s mandate to continue to deliver the top performance that was responsible for the asset growth in the first place.

There have been many instances of small and mid-cap funds that have grown to be so large they have started to invest in larger stocks and ultimately have migrated to another investment style, for example from mid to large cap.

How can funds curb asset bloat? 

Close the fund to new money.  I always respect mutual funds that shut off purchases by new investors in the interest of benefiting existing shareholders.  More assets under management means more money for the fund company.  A shining example of a fund that does this is Sequoia (SEQUX) which has been closed for most of the past 25 years.  The fund’s long-term track record is exemplary.

Start losing money or underperforming.  I say this only partially tongue and cheek.  Nothing will reduce mutual fund assets like a period of underperformance.  Just ask the folks at Fidelity Magellan.  Just as investor money often chases superior mutual fund performance it also has a tendency to flee poor performance.

As Russ Kinnel points out in the Morningstar piece referenced earlier, asset bloat is a symptom of the solid stock market performance we have seen over the past five years.  This is not to say that a large fund cannot be effectively managed.  Case in point is Fidelity Contra (FCNTX).  Manager Will Danoff has done a credible job given the sheer volume of money under his management.  On the other hand American Funds Growth Fund of America (AGTHX) has been called a “closet index fund” meaning that its investments are extremely closely correlated to its benchmark Russell 1000 Growth Index.

For investors in actively managed mutual funds it is important to monitor the fund’s size as one of the indicators that you look at in your periodic review of your mutual fund holdings.  No single indicator is a reason onto itself in determining whether to hold onto a fund or consider selling it, but several key indicators viewed together can help you understand what is happening with your fund holdings.

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Comments

  1. tom brakke says:

    If you’re interested in more on this topic, here are three postings about funds that might be bloated, showing their returns, relative returns, and asset levels.

    Neuberger Berman Genesis (NBGNX), mentioned in the Kinnel piece: http://rp-pix.com/qs

    Fidelity Contrafund (FCNTX), also mentioned by Kinnel and above (and showing a very interesting performance pattern): http://rp-pix.com/qt

    MainStay Marketfield (MFLDX), one of those alternatives sucking up the cash: http://rp-pix.com/qu

    • Roger Wohlner says:

      Thanks Tom. I had caught the Neuberger Berman graph on your site and thought it was excellent. I’ll check out the other links, thanks for sharing. Over the years I can think of several funds that I’ve suggested to 401(k) committees that we needed to replace in large part due to asset bloat. This can be a huge problem with mid caps and small cap funds as you know.

  2. Louise says:

    I remember the adage, don’t get more than what you can chew. This is true in many cases, too much of anything can really be damaging. Thanks for sharing! :)

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  1. […] Just how bloated is your mutual fund?  (Morningstar, Chicago Financial Planner) […]

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