American Fund Managers: Our Funds are Too Large
A fund's asset size represents a conundrum for equity fund managers. On one hand their revenue increases as the fund grows in size. But on the other hand, if the fund grows too large it can handcuff the manager and reduce returns. It presents a direct conflict between the interests of the management company and the interests of the fund's investors.
Most mutual fund organizations talk a good game about how they deal with this conflict, but last week we were presented with some evidence that fund managers are not always pleased when the management company allows their funds to grow too large.
But first a bit of background on why a fund's size can be an issue. The most essential problem is that as a fund grows in size, the pool of stocks that it can own a meaningful amount of shrinks. This often leads to what's known as "closet indexing." A multi-billion dollar fund ends up concentrating its holdings in the large firms that dominate the broad stock market indexes, and the fund ends up behaving a lot like an index fund. That's fine if you're paying an expense ratio of 0.1 percent; not so great if you're paying ten-times that amount for active management. Also, large funds struggle much more with market impact costs than smaller funds do. As they buy and sell the large blocks of stocks that their funds own, that activity is likely to impact the prices of those securities, harming performance.
Obviously, an easy way to prevent these problems and protect the fund's investors is to simply close the fund to new investments. But doing so has a direct impact on the management company's bottom line, because their revenue increases as a fund's assets do.
Smack dab in the middle of the "how big is too big" debate over the past decade has been Capital Group's American Funds, and for good reason: they run six of the seven largest actively managed equity funds, topped off by Growth Fund of America, which has more than $160 billion in assets.
Capital Group has famously declined to close their funds, allowing them to become enormous. They've claimed that their management style allows them to run these huge funds without becoming victimized by their size. Instead of having one or two portfolio managers, their funds rely on management teams. As the funds grow, managers are added, which keeps the amount of money any one manager is running lower.
Doing so, Capital Group has argued, prevents a manager from having to invest new money in anything other than his or her very best investment ideas.
But it turns out that some of those managers weren't fully on board with this logic. According to documents that were released during an excessive fee lawsuit Capital Group was facing, some American Fund managers were concerned way back in 2004 that their funds were growing too big.
The "funds are getting so large that it becomes more difficult to execute mid-cap stock ideas" wrote one manager. Another said that Capital Group should "[c]lose all the funds."
In an interview with Morningstar, one Capital Group executive noted that most of the concerns regarding fund size "came from analysts who hadn't been at the firm very long."
It's possible that this implies precisely what Capital Group believes it does, and that those managers were not familiar with how effective Capital Group's methods of dealing with size are. But it's also possible that the fresh perspective these managers offered on this issue was attributable to the fact that their judgment hadn't been clouded the compensation they had received over the years.
Regardless of which is accurate, there is some evidence that size might be catching up with the American Funds. Since the end of 2007, for instance, Growth Fund of America (which had $193 billion under management at the time) has lagged the S&P 500 Growth index by more than two percent annually. The fund's investors -- many of whom piled in towards the top -- have fared even worse, trailing the fund's return by 1.2 percent over the past three years.
Perhaps this is a mere blip, and Growth Fund of America will resume its outperformance, but investors who believe that might do well to consider the record of the former largest fund in the world, Fidelity's Magellan fund.
After reaching $106 billion in assets in 1999, Magellan has subsequently lagged the S&P 500 by 1.3 percent per year. And like the Growth Fund of America, Magellan's investors have lagged the fund's return, trailing the fund by 1.7 percent over the past decade.
Whether or not Capital Group's enormous funds will be able to overcome the impediments that size presents and outperform their benchmarks going forward remains to be seen. But if nothing else, investors should use a little skepticism when their fund company tells them not to worry, because it turns out that their fund's managers might be just as concerned as the investors should be.