Fund Warning Signs: Asset Growth

(2 of 6)

Fund Warning Signs: Asset Growth

This may seem counterintuitive, but sometimes mutual funds actually need smaller audiences. As funds attract new investors and grow larger, their returns often become sluggish, weighed down by too many assets. They lose their potency, and their returns revert to the average for their group. Some funds stop accepting money from new investors when their assets grow too large, but many don’t. That explains why so many once-hot funds become mediocre.

Keep an eye on your funds

There are worse things than being average, of course. But you may still want to keep an eye on your funds as they grow, especially your small-growth funds. Sometimes mutual fund shops will do the monitoring for you. One small-cap fund, for example, closed in 1997, after asset inflows left the fund with a sizable cash stake that the managers had trouble putting to work. Since its closing, the managers have continued to ply their deep-value style, trawling for small-cap names that are overlooked and misunderstood, and have generated superb, though streaky, results.

One example

Even shops known for their discipline and their great performance can get caught in this trap. One American fund racked up excellent returns in the 1990s picking small firms with lots of growth potential. The management team was vigilant about selling companies as soon as their share prices increased. Investors flocked to the fund, but returns eventually slowed because the managers just couldn’t execute their fast-trading, super-growth strategy with so many assets in tow. So what did they do? They changed their strategy. They now buy larger companies and trade less often, and performance has also moderated.

The fund’s strategy change is a perfect example of how asset growth can affect a fund: fund managers often have to alter their strategies to accommodate new money. Some simply buy more stocks, buy larger companies, or trade less. (When big funds trade frequently, they risk affecting their stocks’ share prices as they buy and sell.) No matter what they do, though, they have to make concessions or close the fund. And as a shareholder, you need to be aware of the change and consider whether or not this altered fund fits into your portfolio. The shareholders of our example fund no longer own a small-growth fund; they own a large-growth fund.

Some types of funds are more hurt by asset growth than others.