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Is Bigger Better? Analysis of Funds’ Size and Performance
From FundScoop Studies and Research Articles
hen a gold-medalist gymnast gained four pounds one week prior to the Olympics games in Sydney, her coach immediately delisted her from the team. Despite her constant pleas, the coach simply told her that the new added weight will hamper her performance. She repeatedly assured him that she would be able to perform just as well, because her skills and experience matter, not her size. His reply was, “Your size is your biggest skill!”
In the mutual fund world, the dispute over how a fund’s size affects performance has been the center of many debates. For many years, fund experts asserted that large funds are often limited by their growing asset base from maintaining the same level of performance levels they achieved before. “The larger a fund becomes,” they said, “the more difficult it is to manage.” The legendary Vanguard founder, John C. Bogle, warned the industry a few years ago that its overwhelming success could be its ultimate demise. Years later, with the fund universe weighting over $7.4 trillion in assets today, we find ourselves determined to answer the question: does size really matter? In doing so, we decided to drop all previously known theories regarding the topic, and instead answer the question based solely on the available historical data showing size and performance side by side.
The Theories
Before we delve deeper into our expedition, let’s first review the reasons for which a large asset base is considered to be a hindrance for a portfolio. First, there is the so-called “market impact cost.” When a fund’s assets grow too large, it becomes difficult for the manager to move in and out of stocks without affecting their price. For example, Fidelity Magellan, the second biggest mutual fund in the US, owned 58 million shares of Citigroup stock as of the end of the first quarter. This portion represents a mere 3.17% of Magellan’s total assets of over a $100 billion.
However, say that portfolio manager Robert Stansky suddenly gets leery about the financial sector’s prospects and decides to trim all of his position in the financial behemoth. With Citigroup lately trading in the range of $50, the dollar volume of this transaction would amount to almost $3 billion dollars. This, of course, is assuming that he sells each of his shares at around the current $50 price range. But the reality is far from that. In order to fullfil the entire transaction, it would take at least 58,000 block trades, 10,000 shares each, to liquidate the position. With an average of 20 million shares of Citigroup trading hands daily, this order would take almost three days to complete, assuming that miraculously Magellan is the only market participant in this stock. But the reality is, it would probably take a week or more to complete the trade fully. Needless to say, these huge sell orders would ultimately bid the price down. By the time the last trade gets through, the stock would have already lost some of its value. Conversely, say that Magellan decides to increase its weighting in the biotechnology sector and decides to invests 2.5% of its assets in Human Genome Science Corp.
This desired weighting amounts to over $2.5 billion of Magellan’s cash going to that purchase. With the stock lately trading at $60, more than 40 million shares would be needed to fulfill that position. At an average daily volume of two million shares, the genome company’s stock would likely move up substantially if this transaction were to be executed. So by the time Magellan buys the last share it wants, the price will already have been pumped up to a much higher range than the one originally sought. In the end, it becomes clear that an inevitable movement in the stock, be it up or down, will not give the fund the results it wants. Another equally critical hurdle a large asset base creates, has to do with diversity. As the asset base grows exponentially, management becomes compelled to diversify its holdings among a large array of stocks. This means that the holdings will represent a smaller percentage in relation to the total portfolio value.
So a huge upward movement in any of these stocks will have a lesser impact on the portfolio’s total return than if in a greater concentration. Again, take the same example of Fidelity Magellan, which has 1.32% of its assets in Oracle Corporation. If Oracle doubles in price and all the other holdings remain unchanged, the US’s second largest fund stands to gain only 1.32%. Of course the reverse is true, if Oracle gets slashed in half, Magellan will only lose 1.32% of its value. But the downside here is that when the assets are distributed among too many stocks, the extent to which the portfolio is affected when these stocks move becomes very benign. Diversification is desired but too much diversification can impede performance.
How Big Is Big?
Now in order to examine how big funds behave, we first have to agree on the definition of “big.” And while we used the gigantic Magellan as an example for demonstration purposes, it’s important to note that the definition of a large fund depends significantly on the fund’s investment category. A one billion dollar micro cap fund may be considered a mammoth compared to its peers, while a fund with the same size in the growth & income category is considered of average size. Of course, this is due to the different price range and volume of the stocks in which these funds invest. But even when examining all categories in isolation, there is no clear-cut threshold at which to deem a fund oversized. Using the mean of the asset bases in each investment category, as a threshold, shows a very inaccurate picture since larger funds are much fewer than smaller ones. The average displays an even more erroneous presentation, again for the very same reason. So, determining where we should plot our boarders—where a fund moves from being normal to being large—proves to be a tough task. To solve the problem, we decided to take the longer route. Instead of just comparing supposed small funds and big funds in each category, we took various different size ranges from each category and examined their performance as a group. And to give a meaningful analysis, we focused our search into the three main diversified equity groups: large cap, mid cap and small cap funds. We took into consideration all pertinent performance time periods, one month, three-month, year-to-date, one-year, three-year, five-year and ten-year. All performance data used was as of end of October 2000.
The Results
The results on the next page showed a startling conclusion. For the shorter time periods, the performance amongst all three categories kept getting worse as we went up the different ranges of asset sizes. For example, in the mid-cap category, for the three-month period, the average group’s performance was 4.16% for funds under $500 million, then dropped to 3.02% for the $500- $1 billion range, then fell to 2.33% for the $1 billion- $5 range, then tumbled to 1.67% for the $5 billion- $10 billion range, then plummeted into -1.12% for the $10 billion-$20 billion range and finally plunged into -5.99% for the biggest range of size, those funds with $20 billion or more in assets. The results so far seem to be in line with the reasons we’ve cited earlier. As the market’s volatility in the past three months continued to be high, smaller funds were more elastic in cashing out of losing positions and moving into better sectors, and thus garnered better returns. But as we examined the longer time periods, three, five and ten years, we found that in each of the three categories, the performance just kept getting better as we moved up the six asset ranges.
Cause Or Effect?
Should we conclude that bigger funds perform better than smaller funds? Do bigger funds manage to attract better managers, and thus beat less experienced managers in smaller funds? The answer to the first question is rather tricky. A mutual fund gets very big after showing a proven performance track record. Janus Fund didn’t attract over $50 billion in assets overnight. The fund has constantly topped the performance charts, and today ranks in seventh place for the 20-year time period. So long-term strong-performing funds, which attract huge assets as a result, are usually likely to maintain the same superior performance, at least for the long haul. Additionally, as these funds continue to garner positive returns, their asset bases continue to grow even further as a result of this capital appreciation. So while at first glance, it may seem that bigger funds perform better, it’s actually more like the other way around, better funds simply get bigger.
An Easy Conclusion?
So does size really matter? Sure it does. But it’s hard to determine to which degree size affects performance, since it’s virtually impossible to isolate and account for all the factors that contribute to performance before and after a fund gets big. Not to mention that there is no clear definition of when a fund is actually considered big. So the question rather becomes: have big funds been able to perform better than smaller funds? As we have shown, smaller funds are able to navigate easily and quickly during downturns and over shorter time periods. But without a doubt, over the long run, bigger funds steal the crown, outperforming their smaller counterparts. It’s safe to conclude that these big funds are indeed well worth their size.
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