When fund performance lags, look for signs of 'asset bloat'

Can a mutual fund become too plump for its fiscal britches? Certainly, says a growing chorus of fund industry observers, who are troubled by the failure of many fund families to shutter funds whose success has led to what's called "asset bloat."

"A key challenge for investors is picking funds whose asset bases haven't become too fat to be handled effectively," says Russel Kinnel, director of fund research at Morningstar, Inc. A fund with $1 billion of assets under management has to invest differently from a fund with $100 million in assets, he notes. And while there is no clear-cut statistical correlation between asset size and performance, too large a pool of assets or a sudden influx of cash over a short span can limit a fund's ability to meet its objectives.

The problem has become more acute lately because a six-year rally in small-cap stocks has led performance-chasing investors to plow more money into the type of funds that are most sensitive to cash-obesity issues. The number of small-cap funds with more than $1 billion in assets has almost tripled in the past five years, and now exceeds 80, according to Morningstar. At the same time, an increasing number of small-cap funds have closed well before reaching the $1 billion mark, "a positive sign of shareholder-friendly management," notes Steve Doucette, a partner at Proctor Financial in Wellesley, Mass.

As their girth expands, small-cap funds are more likely to have trouble executing their strategies than their large-cap counterparts, experts say. "Any fund that focuses on smaller-cap fare loses some of its competitive edge when it has to drag around several billion in assets," says Mr. Kinnel. That's because a large asset base makes it harder to build and exit positions in small-company stocks without affecting the securities' prices. Bloated funds often can't buy or sell meaningful positions in a stock rapidly, limiting their flexibility. If its asset size swells too much, a fund may gravitate toward mid-cap stocks with better liquidity, possibly diluting future performance. "A manager then loses the ability to own promising companies in the early stages of their growth cycle," says Matt Di Filippo, senior portfolio manager at S&T Wealth Management in Indiana, Pa.

The problem of asset bloat isn't necessarily limited to small-cap funds. Large-cap funds with asset bases that are too plump, generally $20 billion or more, can become almost like index funds as managers add more stock positions. "In that case, why pay a 1 to 2 percent management fee if the manager doesn't add value?" asks asset manager Chris Neubert of Moneco, based in Southport, Conn.

It isn't easy to identify asset bloat, experts say. Does a fund begin trailing its peers in performance for a year or longer? Does it hold a sizable amount of cash compared to the historical norm? An unexplained change in management style may also be the result of asset bloat.