NEW YORK (TheStreet) -- Fairholme (FAIRX - Get Report) ranks as one of the fastest-growing mutual funds of all time. Assets in the portfolio increased from $49 million in 2002 to $18.8 billion in 2010. What drew investors were eye-popping returns. Beginning in 2004, the fund finished in the top quarter of its category for seven consecutive years. But the streak has ended abruptly. This year, the fund has lost 25.3%, trailing 99% of its peers, according to Morningstar.Some shareholders fear that the fund has simply gotten too big. All too often, big funds become unwieldy to manage, and their returns suffer. Academic researchers have long known that small funds tend to outdo large ones. The issue of size is a particular concern in today's volatile markets because Fairholme is not the only large fund that is disappointing shareholders. Other giants that have finished in the bottom half this year include American Funds Growth Fund of America ( AGTHX - Get Report), Davis New York Venture ( NYVTX ), Dodge & Cox Stock ( DODGX ) and PIMCO Total Return ( PTTDX ). Shareholders have been dumping the giants, and some financial advisors have begun to believe that the former champions have simply gotten too big. But Fairholme's portfolio manager Bruce Berkowitz says that his problem is not size. Berkowitz has a point. While size presents a handicap for most funds, Fairholme and some of the other struggling giants are exceptions to the rule. Because of their unusual approaches, these big funds should be able to deliver competitive returns over the long term. There is no clear guideline about when funds become too big. But as a rough rule of thumb, Morningstar says that portfolios of large-cap stocks may become unwieldy when assets top $18 billion. Above that line, some funds close to new investors in an effort to avoid bloat. To appreciate the hazards of bloat, consider Fidelity Magellan ( FMAGX ). When Peter Lynch took over the fund in 1977, it was a racy portfolio with $22 million in assets. During the 1980s, Magellan set performance records. But after it topped $60 billion in assets in 1997, the fund became a mediocre performer. During the past 15 years, Magellan has lagged 77% of its peers.
Part of Magellan's problem is surely that the large size makes trading difficult. Consider that the fund now has $19.3 billion in assets. A large holding is Toll Brothers ( TOL), a homebuilder that accounts for 1.3% of the fund's assets. Now suppose that the Magellan portfolio manager wants to double his position in the homebuilder. To do that, he must spend $207 million to buy 12.8 million shares. But Toll Brothers only has 168 million shares outstanding, and 2.8 million trade each day on average. So the Magellan manager will not be able to make his trade right away. Instead, he'll have to spend weeks slowly accumulating shares. And as he places bids with brokers, the fund's purchases will put upward pressure on share prices. The manager may start buying at $16 and complete the position only when the price has climbed to $18. In contrast, a small fund could take a position in a day. Like Magellan, Fairholme must make its trades gradually. But Fairholme has a big advantage because it only holds a few positions and often does little trading. While Magellan owns 229 stocks, Fairholme only owns 22. Top holdings include American International Group ( AIG), Bank of America ( BAC) and Morgan Stanley ( MS) . Berkowitz aims to buy unloved stocks and then hold for years. At the moment he is lagging because financial stocks are out of favor--not because his fund has high trading costs. Berkowitz claims that Fairholme's large size actually provides an advantage. Because the fund buys in bulk, it can sometimes negotiate special deals and influence the managements of the portfolio holdings. Despite the poor recent performance, Fairholme continues to maintain a stellar long-term record. During the past 10 years, the fund has returned 8% annually and outdone 99% of its competitors. Among the biggest funds is American Funds Growth Fund of America, which has $151 billion in assets. For years, advisors warned that the fund had gotten too big. Undoubtedly the bulk has slowed trading, but the fund has still maintained a strong long-term record. During the past ten years, Growth Fund of America has returned 3.2% annually and outperformed 79% of competitors in the large growth category.
Part of the success can be attributed to its relatively low expense ratio. Because of its bulk, the fund enjoys economies of scale and can afford to charge annual expenses of 0.69%, compared to 1.34% for the average large growth fund. In addition, Growth Fund of America avoids some of the problems of bloat by using an unusual management structure. The fund employs nine managers, and each is given a separate piece of the assets to oversee. In effect, every manager oversees a portfolio of about $10 billion to $15 billion, a manageable size. This is very different from typical funds, which lump all assets in a pool that is overseen by one manager or a small team. The biggest fund of all is PIMCO Total Return, an intermediate-term bond fund with $242 billion in assets. Portfolio manager Bill Gross long argued that his fund was not too big because it focused on sectors such as government bonds and mortgage-backed securities, enormous markets that enable easy trading. Gross has argued that his size provides an advantage because he can negotiate favorable terms with brokers. PIMCO typically makes a series of small bets, emphasizing Treasuries one year and foreign bonds the next. Most of the calls have paid off. During the past ten years, the fund has returned 6.7% annually, outdoing 93% of peers. Earlier this year, Gross became concerned that interest rates would rise, a development that could hurt bond prices. To avoid trouble he held cash and shifted to shorter bonds, which suffer less damage when rates climb. The move proved off target. It was an example of Gross making a rare mistake. The poor results should not be attributed to a bloated portfolio.