The Big Money

What’s wrong with $100 billion mutual funds.

When it comes to investing, size matters. More is often better if you invest in mutual funds and also if you manage mutual funds. After all, management fees are calculated as a percentage of total assets.

But size also kills. When mutual funds grow too big, they become unwieldy—a point illustrated by last week’s resignation of Robert Stansky, the longtime manager of the once-mighty Fidelity Magellan Fund.

The law of large numbers dictates that it’s difficult to sustain performance and growth when you’re really big. The Magellan Fund, the largest mutual fund for most of the last 25 years, is a case in point. Running Magellan is probably the highest-profile and most difficult job in money management. It’s like managing the Yankees. You’ve got to follow in the footsteps of some hall-of-famers, and your every move is closely scrutinized. (This piece from Investors Business Daily shows the impressive performance of the 42-year-old fund under managers like Fidelity founder Edward Johnson and Peter Lynch.)

The last two Magellan managers have struggled. Jeffrey Vinik’s tenure was cut short after four years, thanks to an ill-timed bet on bonds. His successor Stansky didn’t have much better luck over the long term. Although Magellan closed to new investors in 1997, its assets continued to grow, topping out at near $110 billion in August 2000. Since then, the fund’s assets have shrunk, thanks to losses and investors yanking out cash. (Here’s a chart of the fund’s performance.) Today, Magellan is about half of its peak size.

Stansky and other managers of giant mutual funds operate under several handicaps. When you have to buy as much as they do, it’s difficult to open and close positions quietly. Hedge funds and other quick-fire traders are constantly trying to suss out which stocks the big dogs are buying and selling and how they can profit by jumping in and out ahead of them. And unless you want to buy hundreds upon hundreds of positions—in which case you’re essentially mimicking the broader market—a huge mutual-fund manager has to confine himself to huge stocks. (To see Magellan’s holdings, go here and click on “Prospectus & Reports.”) Magellan has 207 positions, and its top 10 holdings are the same giant stocks that everybody owns: General Electric, Microsoft, Exxon Mobil, AIG, Home Depot, Citigroup, etc.

Of course, performance is only one reason funds get big and remain big. People also invest based on brands, past performance—although they are constantly warned not to—tips, momentum, and fads. When investors believe that individual stock-pickers can beat the market they’ll invest with them, and those pickers’ funds will swell—even after they stop outperforming. That’s what happened with Magellan in the 1990s, when it kept expanding despite mediocre long-term performance. Post-bust, investors became more interested in indexing. And so in April 2000, the Vanguard 500 Index fund became the biggest mutual fund, a title it held through the bear market, as the S&P 500 fell and then recovered. (Here’s a 10-year chart of the Vanguard 500 fund.) But now many investors are finding that investing in index funds when the index is moving sideways is unsatisfying.

So, there is a new trend in large funds: the mutual fund that tries to imitate hedge funds. Of course, most investors don’t qualify to invest in hedge funds, but they admire hedge funds’ adventurous tactics and look for mutual funds that have some of that moxie. One fund that has benefited is American Funds’ $117 billion Growth Fund of America, which this year replaced the Vanguard 500 as the largest fund. The fund’s assets have tripled during the last four years, thanks to its market-beating performance. And it now has 3.6 million shareholder accounts. This was a list of its holdings as of June 30, 2005.

The secret to its success? Parent company American Funds managed to stay out of trouble and put up a lot of good numbers in a period when rival companies like Janus were covering themselves in ignominy. The fact that Growth Fund of America has crushed the S&P 500 during the last two years has also helped. And while Growth Fund of America isn’t a hedge fund by any stretch of the imagination, it mimics them in some ways. Unlike Magellan, which is managed by a single emperor, Growth Funds’ assets are divided into several portfolios managed by individual managers, each with his or her own team of analysts. They take a more catholic approach to investing than Magellan did, with more foreign stocks and corporate bonds, for example.

There’s one crucial place at which Growth Fund of America parts company with hedge funds. While hedge-fund managers have a lot of self-confidence—managing the money of really rich people requires abnormally high levels of self-confidence—they know that to try aggressively to manage $10 billion or $20 billion is to tempt the market gods. As a result, many hedge funds close funds or simply return cash to investors when they get too big. Mutual-fund companies like Fidelity and American Funds know, intuitively, that size is a barrier to performance. But because they covet market share and management fees, they have plenty of incentives to keep the funds open even as they surpass the $100 billion mark.

The managers of Growth Fund of America have beaten the market while amassing the largest pile of assets in the mutual-fund universe. But if history is any guide, they won’t be able to continue to do both for long.