Size Does Matter for Managed Funds

By David McEwen

Saturday 10th March 2001

There is no shortage of advice in the world about how to pick a managed fund. One golden rule is be wary of investing in last year's winners because sustained outperformance is extremely difficult to achieve.

However, a piece of research from the US caught my eye recently.

Investment site FinancialCounsel.com has tried to figure out whether large funds or small ones are generally the better performer.

There are arguments for both sides. For example, those who support small funds point out that large ones suffer from what is known as "market impact cost." When a fund's assets grow very large, it becomes difficult for the manager to move in and out of stocks without affecting their price.

Based on the typical daily trading volumes of even blue chip shares, the amount of shares in some companies owned by our largest managed funds could take days to sell. Such sustained selling pressure would almost certainly push down the share price.

On the other hand, when a major fund buys a share, the amount needed to have a meaningful impact on its portfolio would be so large that its purchase orders would drive up the price.

From this perspective, small funds are more nimble and effective. Diversification is another issue. As the asset base grows, management becomes compelled to diversify its holdings among a large array of shares.

This means each holdings will represent a smaller of the total portfolio value. Therefore, a huge upward movement in any single share will have a minimal impact on the portfolio's total return. Diversification is generally a good thing but too much can actually impede performance.

The case for big funds is that they have economies of scale, can afford to attract more and better managers and have the clout to actually influence what goes on inside some companies.

To measure the performance of funds large and small, researchers looked at the three main diversified equity groups: large, medium and small capitalisation. They also looked at several performance periods from one month up to ten years.

For the shorter periods, the performance amongst all three categories kept getting worse as the asset sizes of funds grew larger. For example, in the mid-cap category over three months, funds with a portfolio worth less than $US500 million achieved an average return of 4.2%. Returns slid steadily as funds grew in size until the largest ones, with US$20 billion or more in assets, produced a loss of 6%.

Over that three months, smaller funds found it easier to cash out of losing positions and switch into better sectors, and thus achieved better returns.

But as the study examined longer periods, three, five and ten years, it found that in each of the three categories, the average performance improved with each increase in average fund size.

FinancialCounsel concludes that size does matter, but that it's hard to be specific when there are so many other factors that influence performance.

"While at first glance, it may seem that bigger funds perform better, it's actually more like the other way around, better funds simply get bigger," the study says.

That reminds me of another golden rule. Whether big or small, look for funds whose returns consistently rank in the top quarter of their sector.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz

Comments from our readers

No comments yet