When Mutual Funds Get Too Big

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.

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