When Bigger Isn't Necessarily Better

Nation's Business, Oct, 1998 by Randy Myers

                  Annualized Total ReturnsThrough June 30

Fund Category        Assets In Fund     One Year

Small-Company Growth $2 Billion And Up    17.22%

Small-Company Growth Under $250 Million   15.22%

Small-Company Value  $2 Billion And Up    18.05%

Small-Company Value  Under $250 Million   17.92%

Fund Category        Assets In Fund        Five Years

Small-Company Growth $2 Billion And Up         22.33%

Small-Company Growth Under $250 Million        13.72%

Small-Company Value  $2 Billion And Up         19.34%

Small-Company Value  Under $250 Million        16.19%

Randy Myers, formerly a writer and editor for Dow Jones & Co. I ., is a financial writer in Dover, Pa.

It's a fact of life: We usually equate bigger with better. Bigger cars. Bigger houses. Bigger paychecks.

That's not necessarily true, though, when you're choosing mutual funds for your company's 401(k) retirement plan. For lots of reasons, big funds sometimes have trouble keeping pace with their smaller peers or even with the performance standards they set for themselves when they were managing lesser amounts of money.

Fund analysts have made this argument for years. They say that the more cash a fund takes in from investors, the harder it becomes for the fund's manager to find a sufficient number of good stocks.

That argument is logical when one considers how most mutual funds operate. To ensure that funds remain prudently diversified, their managers usually avoid owning more than a few percent of the shares of any one company or owning so much stock in one company that it represents more than 5 percent of the fund's total assets.

When more and more cash pours into a fund, the manager is forced to buy bigger and bigger stocks to satisfy the fund's diversification requirements. Before long, the universe of stocks from which it can choose dwindles dramatically.

John Bogle, founder and chairman of the Vanguard Group of mutual funds, quantified this phenomenon last year in a speech before The Contrary Opinion Forum, an investment conference sponsored annually by Fraser Management, a money-management firm in Burlington, Vt.

At that time, Bogle calculated, a $1 billion fund that limited its holdings of any one stock to 2 percent of the fund's total assets or 5 percent of that stock's total shares outstanding could have drawn from a universe of 2,644 different stocks.

But a $5 billion fund with the same diversification criteria could have selected from just 994 stocks. And a similarly restricted $10 billion fund would have had only 352 stocks from which to choose.

In addition to a dwindling universe of potential investments, funds face higher indirect trading costs when they start to buy ever bigger quantities of stock.

Whereas a small fund might be able to acquire 1,000 shares of a particular stock at the market price, for example, a large fund might have to bid higher and higher to fill an order for 100,000 shares of the same company, just to entice a sufficient number of sellers into the market.

How damaging are these factors? In his Vermont speech, Bogle said his analysis of the 38 mutual funds with assets of $10 billion or more at that time revealed that all had outperformed the Standard & Poor's 500-stock index in their formative years, but all except one had lost that performance edge after attaining "elephantine" size.

The implications of all this seem to be clear: All other factors being equal, you should offer the participants in your company's 40 1(k) plan smaller rather than larger mutual funds as investment options.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, suggests that micro-cap funds (those that invest in the very smallest stocks) ideally should have assets of no more than $200 million. He likes small-cap funds to have no more than $750 million in assets, and mid-cap funds to have no more than $4 billion.

Remember, though, that these are only guidelines and that size may not be an impediment to performance in every investment climate. Over the past several years, for example, large-company stocks have outperformed small-company stocks dramatically. As a result, funds that got larger and were pushed into buying bigger stocks generally benefited.

Using Morningstar Principia Plus for Mutual Funds, a CD-ROM database produced by Chicago-based investmentresearch company Morningstar Inc., Nation's Business looked at the performance records of thousands of domestic stock funds in four investment categories for the three-year and five-year periods that ended June 30. In each category, the largest funds outperformed the smallest funds during each period.

John Rekenthaler, head of research for Morningstar, says that analyzing fund performance by current asset size is problematic not only because of the market's bias in favor of large-cap stocks in recent years but also because such analysis does not take into account how big a fund was at the start of the period being studied.

After all, high-return funds tend to be most successful at attracting new investors. As a result, the biggest funds are those whose managers have shown a strong ability to pick stocks.