Shrink Away from Your Big Mutual Funds

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How big is too big? On the surface, that may seem like an unanswerable question. But when it comes to mutual funds, a recent report suggests that there is, in fact, an answer. At the very least, there are warning signs that your mutual fund might be getting too big. And in some cases, bigger is not necessarily better.

Overstuffed Funds

According to the article, investors began a dramatic turnaround in 2002 when the stock market renewed its upward climb. Money that was flowing out of mutual funds in recent years is now pouring back in. For example, since 2002, investors have put more than $450 billion into mutual funds. That, the article notes, can cause problems for investors.

First, large funds traditionally don't trade as handily as smaller ones. Consider that it's a lot easier to buy or sell 250,000 shares of a stock at a good price than it is to buy or sell 5 million shares.

Second, funds that have become oversized are unable to invest as heavily in small cap stocks or other less liquid securities. And according to the article, those are the investments that can often produce the biggest returns.

Lastly, the more money fund managers have to utilize, the more difficult it might be to focus those assets on their best ideas. After all, some fund managers say that they run out of great ideas after 50 picks. And while there is no magic cutoff number to alert you that your mutual fund has become too fat, there are some warning signs.

Out of Hand

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Result:

A mutual fund may be getting too large if its cash stake is too high. The article illustrates that since 2002, assets in the First Eagle Overseas fund have increased nearly fourfold to $6 billion. That rapid inflow of dollars, combined with a rally in foreign stocks, made it difficult for fund managers to find enough investment opportunities. A lot of the money—as much as 26% last February—sat in cash. That can make the fund less risky, but it also lowers a fund's potential return.

If you own a small or mid cap fund, one sign that the fund is getting too big is if the fund takes on a higher average market cap. This could result from the fund manager purchasing bigger stocks to remain fully invested or liquid. And while the style change doesn't always mean that a fund is getting too large, it's a good indication that it might be.

Beware of a fund that has always held a set number of stocks and suddenly increases. Are there that many great, new investments out there? Unlikely, and the danger is that increased cash inflows have forced the fund to purchase second-string stocks, which can water down the fund. The article suggests examining the percentage of your fund's assets that go into its five or 10 largest holdings. If that number declines, your returns might be less impressive in the future.

Funds to Watch

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The article details three funds that may be getting too fat. The first is the Pioneer High Yield fund. Since January 2003, this $8.7-billion fund's assets have increased 132%. The funds manager says the cash inflow is not a problem. However, one of the fund's competitors, the T. Rowe Price High Yield fund, closed its doors at $4 in late February.

Next is the Royce Low-Priced Stock fund. The fund has seen assets increase 94% to $3.5 billion since January 2003 by buying a combination of small and micro cap names. However, the fund manager concedes that the fund will have to change its approach to micro cap stocks.

Lastly is the Fidelity Leveraged Company Stock fund, with an asset increase of 196% since July 2003. The fund places high emphasis on the media, telecom, and utilities sectors. That concentration, the article notes, could be more difficult to execute given the increase in assets.