The Idea That Small Funds Do Better Is a Myth

Astronomers believe that large stars burn out more quickly than smaller ones. Can a similar analogy be drawn with mutual funds?

Certainly, there’s a perception that big funds are relatively dim performers. Managers of undersized portfolios can maneuver more easily, especially in volatile markets. Also, they can invest in smaller companies that are growing at a faster rate--the type of stocks that sometimes double or triple in price within a year.

But before you unload all your big funds, consider this: As a group, the largest growth-stock portfolios have actually done better than their small-fry counterparts in recent years. Growth funds with more than $1 billion in assets rose an average of 143% from 1985 through 1989. Portfolios with less than $25 million increased roughly 85% over the same period. Medium-sized growth funds also couldn’t keep up with their larger rivals.

“There’s a perception that big funds are laggards, until you look at the hard numbers,� says Larry Leonard, manager of Massachusetts Investors Trust, a $1.4-billion fund based in Boston.

Intuitively, it’s reasonable to expect larger funds to fare worse. The giants--especially those with more than $1 billion in assets--can’t jump in and out of stocks quickly. To make an investment worthwhile, they’re practically forced to buy big blocks of shares in a company, and that takes time. Leonard says he usually needs at least two or three days to ease into a position--and at least that long to sell. “It’s one thing to get into a stock, and another to get out,� he says.

Liquidity concerns force most large-fund managers to invest in big stocks--companies such as IBM, Exxon and General Motors. The shares of substantially smaller companies are simply too thinly traded for them to buy. A manager who tried to do so could easily push up the price of a tiny stock simply by virtue of his own trading actions. He would face the opposite, worse problem when he tried to sell.

Besides this liquidity dilemma, the Securities and Exchange Commission prohibits mutual funds from owning more than 10% of the voting shares in a company.

Even if the manager of a behemoth portfolio were able to invest in a small company and it did well, the stock’s appreciation would likely have only a modest impact on the fund’s total return. For example, if a $25-million growth fund invested $1 million in a tiny stock, and it doubled in price, the gain would boost the portfolio’s assets by $1 million, or 4%. But the same-sized profit on a $1-billion fund would increase assets by only 0.1%.

For this reason, some large-fund managers don’t even bother to invest in obscure issues, regardless of how promising they might be. “The manager’s best ideas could get diluted, in that he can’t put a very big part of the fund’s assets into a stock he really likes,� says Joe Mansueto, president of Morningstar Inc., a Chicago-based company that monitors mutual fund performance.

Some funds even “close,� or stop accepting new money, when they reach a certain size. “When a fund closes, the management is making a statement that it’s having trouble running large sums of money,� Mansueto says.

With all these strikes against them, how have big growth funds managed to do so well in recent years? It’s partly a matter of skill. “Large funds have excellent managers,� says Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Hastings-on-Hudson, N.Y. “Their management had to be good, or the funds never would have grown so large.�

Also, big funds enjoy economies of scale because they can spread their operating expenses across a larger asset base. Massachusetts Investors Trust, for example, has an expense ratio of just 0.55% a year, about half that of the average growth fund.

(Economies of scale would also seem to favor large bond funds, but in recent years this hasn’t been the case. Fixed-income funds with assets of $1 billion or more rose roughly 9.8% a year, compounded from 1985 through 1989, according to Lipper Analytical Services. Portfolios with less than $25 million did slightly better, increasing at a 10.1% average annual rate.)

But the key reason why large equity funds have fared well in recent years is that they’ve been holding the right stocks at the right time. Blue chips have led the market for most of the past seven years. The Dow Jones industrial average and the Standard & Poor’s 500--both dominated by large issues--have outperformed small-stock indicators such as the NASDAQ over-the-counter index or the Wilshire 5000.

Jacobs believes that the pendulum will eventually swing back in favor of emerging growth companies. Historically, smaller firms have posted greater profit increases, and their share prices have done better.

However, investors have been waiting for several years--in vain--for the turnaround to occur. Some people feel that the market has changed in ways that might permanently favor larger issues. In particular, institutions and foreign investors now exert a greater influence than in decades past, and both groups tend to favor blue chip stocks. Also, many larger companies have become more competitive.

“Some of the biggest companies have gotten stronger over the past five years,� Leonard says.

All of this suggests that large size by itself isn’t a critical detriment, at least among growth-stock portfolios. However, you can expect big funds to run into trouble when they operate in relatively narrow market sectors.

Several years ago, for instance, convertible bonds were the rage, and convertible-bond funds multiplied like rabbits. Investor dollars poured in, and that forced portfolio managers to compete vigorously for the relatively few convertible issues that came along. Prices got extended, which led to a painful correction in 1987. “If you’re a big fund in a little sector, you’re forced to buy just about everything that comes along,� Mansueto says.

Similarly, Jacobs cautions against owning large funds that concentrate on small-company stocks. He suggests staying away from anything in this sector with more than $300 million in assets. “Size is most important when you’re talking about small-company funds.�

In short, you should pay attention to size when selecting a mutual fund--along with portfolio management, the investment objective, the state of the market and other factors. “It’s one of a mosaic of ingredients,� Mansueto says. “Certainly, the odds are against you with a big fund, but the skills of an outstanding manager can come through.�

BOOM PERIOD FOR BIG FUNDS Small growth stock funds are easier to manage and can invest in a wider range of securities than their larger cousins. Yet big funds have actually done better in recent years. This chart shows approximate annual returns for small, medium and large growth portfolios from 1985 through 1989.

Source: Derived from data provided by Lipper Analytical Securities

HOW MUTUAL FUNDS PERFORMED Average total return including dividends, in percent for periods ended Thursday, Aug.2. TOP 10

Fund Type Notes 12mos. Yr. to date Week Strategic Investments AU L -5.40% -29.59% +6.60% Rushmore: Precious Metals Index AU NL +10.38 -7.54 +5.65 Fidelity Select Energy Services NR LL,R +53.95 +28.52 +5.62 MetLife Equity: Energy Fund NR LL * +3.65 +5.60 Benham Equities: Gold Eq. Index AU L +16.92 -4.95 +5.20 Financial Portfolio: Energy NR NL +17.40 +5.50 +5.10 Strategic Gold/Minerals AU L -5.45 +6.12 +5.00 Vanguard Special: Energy NR NL,R +28.85 +12.14 +4.97 USSA Investment Trust: Gold AU NL -2.90 -13.51 +4.96 SLH Investment: Precious Metals AU NL,R +3.18 -10.25 +4.96

BOTTOM 10

Fund Type Notes 12mos. Yr. to date Steadman Oceanographic G NL -12.00% -10.89% Financial Portfolio: Technology TK NL +17.41 +14.26 Prudent Speculator: Leveraged SG NL -27.13 -14.11 AFA: Natl. Aviation & Technology TK L -4.67 -4.67 Vance Sanders Special Fund G L +2.03 +0.92 Fidelity Select Computers Port. TK LL,R +14.11 +15.02 Steadman Associated Fund EI NL -8.86 -5.26 AIM Equity: Constellation Fund CA L +9.31 +4.47 Twentieth Century: Vista Investors CA NL +14.69 +2.74 SFT: Environmental Awareness S L +4.89 +1.72

Fund Week Steadman Oceanographic -8.09% Financial Portfolio: Technology -7.94 Prudent Speculator: Leveraged -7.66 AFA: Natl. Aviation & Technology -7.14 Vance Sanders Special Fund -6.84 Fidelity Select Computers Port. -6.64 Steadman Associated Fund -6.49 AIM Equity: Constellation Fund -6.44 Twentieth Century: Vista Investors -6.41 SFT: Environmental Awareness -6.22

TYPE: AU = gold, B = balanced, CA = capital appreciation, CV = convertible securities, EI = equity income, EU = European regional, FI = fixed income, FS = financial securities, FX = flexible portfolio, G = growth, GI = growth and income, GL = global-international and U.S. stocks, GX = global flexible portfolio, H = health/biotechnology, I = income, IF = international, MI = mixed income, NR = natural resources, OI = option income, PC = Pacific regional, RE = real estate, S = specialty/misc., SG = small company, TK = science and technology, UT = utility, WI = world income. NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply. * Fund established March 2, 1990 Source: Lipper Analytical Services