Investors like to see their holdings grow, but sometimes they can get too big.
It’s not that you can make too much money. It’s that a mutual fund can get too big for its own good, or yours.
At some point, fund managers may not be able to find enough promising stocks to soak up all the money they have to work with. Or the fund can get so big that it takes too long to build a position in a desired stock before the price goes up, or to unload an undesirable stock before the price goes down.
Very large purchases executed too quickly can increase a stock’s price by raising demand, and vice versa. The problem is especially serious for funds that invest in small-company stocks, since the supply is not very large.
How big is too big?
It’s different for different types of funds, according to a study by Turner Investment Partners, which manages 26 funds. When a fund gets too big, it should “close,” or stop taking money from new investors.
“Capacity is a function of the liquidity that’s available for stocks, namely how many shares trade at what price over time,” Turner research director David Kovacs says in an interview with Morningstar Inc. (Stock Quote: MORN), the market-data firm. “Typically..., smaller companies are less liquid than large companies. Therefore, micro-cap stocks, for example, or micro-cap funds, should close much sooner than, let’s say, mid-cap or large-cap funds.”
While maximum size can be different for two funds with similar goals, depending on what stocks they own, Kovacs offers a rule of thumb investors can follow when picking funds: Micro-cap funds should have no more than $1 billion in assets, small-cap funds no more than $2 billion. Mid- and large-cap funds can still operate efficiently with tens of billions of dollars in assets, Kovacs says.
Turner sets a capacity for each of its funds with a formula that considers five factors: the average number of securities in the fund, the average daily value of stocks traded in the fund’s universe, the maximum number of days it typically takes to build and eliminate positions, the maximum amount of trading that can be done in a day without affecting a specific stock’s price, and the percentage of the portfolio typically held in cash.
Turner’s analysis also concludes that value-oriented funds can safely be larger than growth-oriented funds investing in the same asset class. That’s because value strategies tend to be hunting for bargains, meaning they often buy stocks that have lots of supply and low demand. The value fund’s purchases are therefore less likely to drive the price up before the process is complete, and sales are not likely to drive prices down.
Because Turner is probably the only fund company that discloses its analysis of maximum advisable fund size, investors concerned about this will have a hard time. One approach is to stick with index-style funds.
Since indexers use a long-term, buy-and-hold strategy, their managers generally don't do the kind of large trades that can drive a stock’s price up or down. Indexers simply hold the stocks in an underlying market gauge like the Standard & Poor’s 500, so there’s not likely to be a mad rush in and out of any particular stock. Indexers also generally charge lower fees than managed funds.
Exchange-traded funds also minimize problems related to getting too big, as most of them use an indexing strategy and do not have to make rapid changes in their portfolios.
Unlike mutual funds, for example, ETFs do not have to sell stocks to raise cash for investor redemptions. The investor getting out of the fund simply sells her shares to another investor, and there is no change in the ETF’s stock holdings.
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