Dear Analyst,
I am considering moving some money into a municipal bond fund, and I have selected two possible funds. Both are similar in many aspects, with the biggest difference between them being asset base size. One has an asset base of $1.5 billion and the other $86 million. Does size give any competitive advantage or disadvantage?
The size of a fund's asset base might not be the first thing you think of when considering a fund. But asset size actually tells you some very important information. Unfortunately, it's not quite as simple as "big is bad, small is good" or vice versa. Read on to learn about how assets play a role in bond and stock funds and whether you should be concerned about your fund's asset base.
For those who aren't familiar with the concept of asset base, let's start with a quick definition. A fund's asset base is simply the total number of dollars under management for a particular portfolio. Take AmSouth Large Cap (ILCAX) as an example. Right now, manager Ron Lindquist is overseeing $426 million across all three of the fund's share classes.
Asset size affects different parts of a fund's operations differently. First, asset size generally has an impact on costs. Growing funds usually enjoy economies of scale: As the asset base gets bigger, a fund's expense ratio usually goes down because management is taking its fees off a larger pool of dollars.
A fund company that is charging 1 percent on a $1 billion fund, for example, is making a lot more than a firm charging 1 percent on $100 million. Hence, the firm with the bigger fund can generally afford to reduce expenses. Of course, the inverse is also true: A fund whose asset base is shrinking can see expenses rise.
A large asset base can also affect a manager's flexibility. A manager who is overseeing a few million dollars can trade in and out of stocks and even dabble in illiquid securities - stocks or bonds that aren't widely traded. (Not all managers choose to do this, of course.) As the fund's asset base grows into the billions, it can become more challenging to trade in and out of securities.
However, stock fund managers are disproportionately affected by this problem, as we'll talk about below.
With bond funds, the issue of asset size is fairly straightforward. Generally, bond funds become more appealing as they get bigger, in large part because they usually get cheaper.
Costs may not seem like such a big deal on the surface - after all, how much can it matter if a fund charges 0.5 percent or 1.0 percent? But those seemingly minor differences can have a big impact on the long-term returns of your bond fund. That's because the gap between the best performer in a bond category and the worst performer can be fairly narrow (sometimes 1 or 2 percentage points), so you can do yourself a huge favor by looking for a cheaper bond fund - which often means a bigger bond fund.
Can a bond fund get too big? Certainly, but for straightforward bond funds it can take many billions. Generally, bond-fund managers can handle large asset bases more easily than their stock-focused compatriots. Because the bond market is far larger than the stock market, bond managers find it fairly easy to trade in and out of securities even if they're managing large sums of money.
Of course, PIMCO Total Return (PTTRX) is testing these limits with $65 billion in assets, but thus far manager Bill Gross hasn't faltered.
There is the occasional exception to this rule. Bond funds that dabble in nonrated bonds or illiquid areas of the market can be encumbered by a large asset base. But straightforward bond funds, especially those that focus on the U.S. Treasury market, shouldn't face too many liquidity problems.
On the stock side, the picture is a little cloudier. On the one hand, the cost story is similar for stock funds. As equity funds get bigger, they usually get cheaper. Although costs don't have as much impact on the stock side, they're still an important predictor of performance over the long term.
But the liquidity issues can be trickier on the stock side. On the large-cap end of the market, where managers are trading in and out of widely held, name-brand stocks like Microsoft (MSFT), General Electric (GE), and BP Amoco (BP), a large asset base isn't usually a problem - up a to a point. (Blue-chip companies have a huge number of shares available on the market and generally there are lots of buyers and sellers available.) A large-cap manager overseeing a $4 billion or $5 billion portfolio shouldn't find it too hard to execute trades.
But even in large-cap land, managers eventually feel the burdens of a large asset base, especially if they trade a lot or run a focused fund.
Take, for example, Janus Twenty (JAVLX): At its peak manager Scott Schoelzel was running nearly $37 billion. Even now, the fund sports a huge $10 billion asset base and takes huge positions in individual stocks. That means when Schoelzel wants to exit a position, he has to sell a huge number of shares. Selling big chunks of a stock can depress the share price, which makes the situation less than ideal for a manager.
Big fund companies use all sorts of strategies to try to circumvent these trading challenges, but the fact of the matter is that huge stock funds usually lack flexibility.
The liquidity situation is far more acute for small-cap funds. For one thing, small-cap companies often have only a limited number of shares on the market. Therefore, a fund with a large asset base can find it difficult to establish a meaningful position without buying up a huge chunk of the company's outstanding shares.
In addition, many small-cap stocks are thinly traded, so a manager with a sizable stake in a tiny company may find it difficult to sell shares
Although there's no fixed figure, a good rule of thumb is that a small-cap manager can start to find asset size a problem around $1 billion. In fact, you'll often see fund companies close the doors of their small-cap funds to new investors when those funds' asset bases reach the $1 billion mark.
As a result, you may want to avoid a small-cap fund with a huge asset base - especially if its relative performance has flagged in the face of large inflows.
Of course, you can't consider the issue of asset size in a vacuum. You can find some big bond funds with less than stellar records, like American Funds Bond Fund of America (ABNDX). And some stock-fund managers have defied common wisdom and thrived despite big asset bases.
Joel Tillinghast, who runs the small-cap blend fund Fidelity Low-Priced Stock (FLPSX), is a perfect example. Low Priced Stock - which now sports an astonishing $14.5 billion asset base - has closed and reopened its doors several times to help manage inflows. But throughout, Tillinghast has delivered an enviable record, in part because his strategy has always revolved around holding small positions in a huge number of stocks.
In the end, asset size shouldn't be the only reason you buy or sell a fund, but it can influence your decision.