Chapter 12

On Asset Size

Nothing Fails Like Success

In the short span of two decades, mutual funds have grown from a mom-and-pop cottage industry to a financial behemoth. The great American mutual fund boom has multiplied equity fund assets fully 82 times, from $34 billion 20 years ago to $2.8 trillion presently. The old saying “Nothing succeeds like success” surely describes the industry today. As the great 16-year bull market has soared, investors have flocked to mutual funds in numbers not even dreamed of two decades ago.

But there is a contrary expression: “Nothing fails like success.” The massive asset size and transaction volume of mutual funds (by portfolio managers and shareholders alike) have created serious problems, along with an important set of limitations for the industry. If small is beautiful, mutual funds are not as pretty as they once were.

The industry today differs not just in degree but in kind from what it was as recently as a decade ago. As a result, the past is unlikely to be prologue. The way we look at equity mutual funds must change, to reflect today’s realities and those that we will continue to face in the years ahead. The history of mutual fund performance relative to the market is not likely to be very relevant to how mutual funds perform in the future. Nonetheless, despite having had the opportunity to outpace the market in an earlier era, mutual funds failed to do so by a wide margin.

Isn’t Bigger Better?

Mutual funds—now holding $2.5 trillion of U.S. equity securities—control more than 21 percent of corporate America. At the start of 1982, just before the great bull market began, when the total value of U.S. equities was $1.3 trillion, fund holdings totaled $40 billion, or just 2.8 percent of the total. (See Figure 12.1.) This extraordinary eight-fold increase in percentage ownership, so rarely noted, has important implications. And the control continues to grow. By the century’s end, one of every four shares of stock—or four of every ten shares, if we include shares held in other investment accounts run by mutual fund managers—may well be effectively controlled by mutual funds.

In 1982, mutual funds constituted largely a stand-alone industry that was focused almost entirely on its own business. Few were units of financial conglomerates that also provided asset management services directly to individuals and institutions. Today, only three of the 25 largest fund complexes provide their services solely to mutual funds. The conglomeration of fund complexes with one another, and with banks, trust companies, insurance companies, and brokerage firms (to say nothing of railroads, glass makers, and airlines), national and international alike, has reached epic proportions.

FIGURE 12.1 Fund Manager Ownership of U.S. Stocks

As a result, the ownership of equity securities by mutual funds alone severely understates, by fully one-third, the importance of the investment power and impact of the firms that manage funds. These firms also manage separate investment accounts for institutional clients and wealthy individuals. Their value, currently estimated at $1.5 trillion, brings the total ownership of stocks by accounts managed by mutual fund advisers to some $4 trillion, or some 33 percent of the $12 trillion market capitalization of U.S. equities. Such a concentration of ownership—without parallel in American financial history—continues to grow apace.

But that ownership, in a sense, is not the most important issue. Given the vigorous, highly active investment strategies adopted by most mutual funds—annual portfolio turnover in equity funds has soared to nearly 90 percent—as much as half (or more) of all U.S. stock transaction activity is accounted for by this relatively small group of managing institutions. It is not ridiculous to assert that they are the market.

What are the implications of that situation? Let’s begin by focusing on mutual fund ownership of individual securities. Figure 12.2 shows fund holdings of the 10 stocks with the largest U.S. market capitalization. Note the curiously wide range of holdings: less than 5 percent of Coca-Cola; some 6 percent to 10 percent in Exxon, General Electric, Microsoft, and Intel; nearly 19 percent of Merck. Compare these to the overall average share ownership of 21 percent of all stocks owned by the industry. These high-performing—and obviously underowned—stocks led the way in the 1996-1998 bull market, and helped drive the index fund boom.

Since index funds and index pools held 8.0 percent of the total value of the Standard & Poor’s 500 Stock Index, it follows that they owned 8.0 percent of the shares of each one of the large stocks in the index. (Their portfolios contain an equal percentage of the shares of each stock.) So the prices of these giant issues may have been given some of their upward momentum, not by the demand of index funds, but by the demand created by active managers who were fearful of their underweightings and anxious to lose no further ground to the spectacular index fund returns.

FIGURE 12.2 Fund Ownership of the Ten Largest Stocks

	Held by Active Mutual Funds*
General Electric	9.8%
Microsoft	9.3
Coca-Cola	4.5
Exxon	6.5
Merck	10.8
Pfizer	12.6
Wal-Mart	12.7
Intel	9.4
Procter & Gamble	8.3
Bristol-Myers Squibb	16.0
* As of June 30, 1998.

TEN YEARS LATER FIGURE 12.2 Fund Ownership of the Ten Largest Stocks

	Held by Mutual Funds**
ExxonMobil	11.0%
Microsoft	20.0
Wal-Mart	11.0
Johnson & Johnson	15.0
Procter & Gamble	13.0
AT&T	19.0
IBM	16.0
Chevron	19.0
Google	24.0
General Electric	12.0
**As of May 31, 2009.

In its ownership strategy, then, the fund industry has a substantial relative bias against the equities with the largest market capitalizations, and in favor of mid-cap and small-cap shares. Figure 12.3 shows that, in this pattern of ownership, participation rises as capitalization levels decline. Compared to a “par” of about 21 percent—their share of all U.S. stocks—fund ownership equals 15 percent of the 100 stocks with market capitalizations over $23 billion. This percentage grows uniformly as capitalization size shrinks, to 21 percent of the 300th to 600th largest stocks, to 36 percent of the 100 stocks ranked 901 to 1,000 in size, falling then to 21 percent of the remaining 6,300 stocks with capitalization of less than $500 million. This reversal of trend for very small stocks presumably relates to their limited liquidity.

One implication of the industry’s giant size is that these dominant ownership percentages represent the “big stick” now carried by

FIGURE 12.3 Fund Ownership by Market Capitalization

Equities Grouped by Size	Equity Fund Holdings*
1-100	14.8%
101-200	18.7
201-300	20.2
301-400	20.9
401-500	21.0
501-600	21.7
601-700	23.6
701-800	25.4
801-900	29.2
901-1000	35.7
1001-7300	21.6
*As of June 30, 1998.

mutual funds (and their associated asset pools) in corporate governance. The funds so far have followed President Theodore Roosevelt’s advice to “speak softly and carry a big stick,” but their institutional brethren in the state and local government pension fund arena have shown no similar restraint. Nonetheless, it is fair to say that the latent power of fund ownership, added to the dynamic power represented by the ownership of the huge state and local asset pools, has helped bring about the truly revolutionary focus on creating shareholder economic value that has helped awaken corporate America to the responsibilities it owes its owners. In this somewhat perverse sense, funds can be said to have helped create the great boom in earnings that U.S. corporations, by focusing intently on shareholder value, have enjoyed in recent years.

Another implication of the funds’ giant size is that mutual fund shareholders have played an increasingly powerful role in shaping stock market returns. The increase of fund ownership from less than 3 percent to 21 percent of U.S. stocks in 16 years has meant that fund shareholders themselves have fueled the demand for stocks, which has helped drive stocks upward. But these same fund shareholders have also created new risks to market liquidity. To the extent that they demonstrate a herd instinct, shareholders could endanger the very liquidity that mutual funds pledge to offer. The fact that this obvious and implicit risk has so far manifested itself only by adding to the demand for stocks should not blind us to the reality that any significant run of fund redemptions would create downward pressure, perhaps of major dimension.

TEN YEARS LATER

Asset Size

Since the publication of the previous edition, assets of equity mutual funds soared from $2.8 trillion in 1998 to $6.9 trillion in October 2007, only to tumble back to $4.0 trillion in mid- 2009. In 1998, funds owned 19 percent of all U.S. stocks (up from 3.1 percent in 1981); at the peak, the ownership share reached 29 percent, and has since declined to 24 percent.

In retrospect, mutual funds have been part—albeit the major part—of a wave of institutionalization of equity ownership of our nation’s corporations. Together with corporate pension funds, state and local pension funds, endowment funds, and other funds managed by professional investment organizations, institutions control some 75 percent of the stock of all U.S. corporations, compared to a mere 13 percent in the 1950s, and only 20 percent as recently as 1968.

During this period, any bright line that existed between mutual fund managers and the managers of corporate pension funds has been virtually erased. Among the 50 largest money managers in the United States, fully 48 manage the assets of both mutual funds and pension funds. Thus, considering only the mutual fund assets of these behemoths dramatically underscores how difficult it is for them to either acquire or liquidate stock positions.

I wrote earlier that increased fund ownership of stocks “has helped bring about the truly revolutionary focus on creating shareholder economic value that has helped awaken corporate America to the responsibilities it owes its owners.” I was just plain wrong. The ownership society—in which individuals owned more than 90 percent of stocks—gave way to the new agency society, with individuals holding just 25 percent. These agents have largely failed to honor the interests of their principals—notably mutual fund shareholders and pension plan beneficiaries—allowing our corporations to be run to far too great an extent in the interests of their managers rather than their shareholders. (Think executive compensation, for example.) Even worse, corporate managements were able to persuade professional investors to accept the canard that the creation of shareholder value is represented by the price of the company’s stock. The market’s embrace of that absurd theory in turn led to earnings management, “financial engineering,” debased account ing standards, and many ill-advised mergers and business combinations. Together, this triumph of speculation over investment in fact usually reduced the intrinsic value of corporate America.

Size and Fund Investment Returns

But the final implication of the dominant fund ownership of stocks—fund performance relative to the market—is my main focus here. I believe that the industry’s giant size is apt to impede—indeed eliminate—any potential that mutual funds as a group might otherwise have had to offer superior returns. Paradoxically, if the growth of mutual funds, by helping to add value in the corporate world, has had a positive impact on stock returns, it has also had a negative impact on the value that the fund industry can add for its own shareholders. Simply put, it is at least possible to imagine that a mutual fund subset owning less than 3 percent of the stock market could outpace the market itself, but it is virtually inconceivable that a fund subset owning 21 percent could do so. And to suggest that a subset of 33 percent (including funds and their associated asset pools), and doing one-half of all stock transactions at that, could turn the trick would tax one’s credulity. In an efficient market, an aggregation of one-third of all investment assets does not outpace the other two-thirds. It is simply too much to expect.

In 1975, I gave the Vanguard directors data on fund returns for the period from 1945 to 1975. Compared to the Standard & Poor’s 500 Index, the average equity fund had experienced an annual shortfall of -1.6 percent. That figure dropped to a cumulative -0.8 percent through 1981. Since then, funds have fallen behind the S&P 500 Index by a far larger amount, -3.7 percent annually in the period from 1981 to June 1998 (although part of that increased margin is accounted for by the index’s large-cap bias). Most of it is doubtless caused by the rise in both mutual expense ratios and costly portfolio turnover.

The industry as a whole, given its massive size, is truly in a straitjacket. The fleet-footed cheetah has become the lumbering pachyderm. Any chance, however remote, that mutual funds as a group can outpace a suitably weighted market index (one that includes large and small stocks in similar proportions to those of the industry) is “gone with the wind.”

Put another way, if equity funds as a group are to outpace the market, the last, best hope is through minimization of the fiscal drag that makes winning the game so tough. Funds could reduce advisory fees, marketing costs, and expense ratios; reduce excessive and costly portfolio turnover; and reduce the long-term drag of cash holdings, so easy to do in an age when futures contracts on market indexes are available. None of these trends has developed to date. In the highly unlikely event that they do develop, they could help improve fund returns and give more fund managers the opportunity to live up to their own professional reputations and the expectations of fund shareholders. Funds as a group would continue to trail the market by the amount of their costs, but by a slimmer margin. Such changes could help reduce the industry’s return shortfall against the indexes. But, given the industry’s massive size, there is no longer any chance to eliminate that shortfall.

Real Size, Real Problems

What’s true for the industry is also true for large individual fund components. These dominant mutual funds have reached mammoth size—indeed, two large funds, the $75 billion actively managed Magellan Fund and $64 billion Vanguard 500 Index Fund,^y each have more assets than all equity mutual funds combined held at the start of 1983. Seventeen other funds now have assets above $20 billion each. All told, the 48 stock funds with assets of $10 billion and above control more than $1 trillion of equities.

What happens when funds grow to large size? Consider the experience of five of the largest actively managed equity funds, whose aggregate assets grew from $500 million to $37 billion during the 1978- 1998 period; uniformly their performance deteriorated. Figure 12.4 shows their average annual returns, relative to the Standard & Poor’s 500 Index, along with their asset size relative to the total stock market. The pattern is familiar: profound reversion to the mean (RTM), the same situation that we witnessed in Chapter 10. While RTM is one of the most pervasive rules of the financial markets, there are exceptions that can persist for periods as long as 15 years (or more). As documented in Figure 12.4, however, the attainment of huge size turns that rule from near-pervasive to all-pervasive. From the start of 1978 to the end of 1982, these five large funds amassed a large performance edge over the Standard & Poor’s 500 Index, outpacing the benchmark by 10 percentage points per year. They achieved that performance edge when they were relatively small (indeed, their performance fostered their growth), with average assets of $500,000 for every $1 billion of stock market capitalization. They lost the edge when they attained elephantine size. Since the start of 1994, with relative assets reaching $3.5 million for every $1 billion of stock market capitalization, these five actively managed funds have lagged the Standard & Poor’s 500 Index by more than 4 percentage points per year. In other words, as the managed funds’ relative assets rose sevenfold, their relative performance suffered a net decline of more than 14 percentage points annually. This size increase almost certainly played a major role—probably a starring role—in this remarkable example of reversion to, and then below, the mean.

FIGURE 12.4 Five Largest Equity Funds (1978 to June 1998)

TEN YEARS LATER FIGURE 12.4 Five Largest Equity Funds (1978 to 2009)

Measuring a Fund’s Real Size

Consider for a moment a question that is almost never part of the public debate about fund size: What is the relevant unit of size? Rather than the size of the fund itself, the unit of measurement ought to be the total asset base of the organization that manages an individual fund. By this standard, a large fund may in fact be two to three (or more) times the size that it appears to be. To the often-pervasive extent that other funds in the same complex (or institutional accounts managed by the same organization) own the same stock—given firmwide policy constraints on percentage ownership of a given stock, transaction allocation procedures, and limitations on market liquidity—the problems of size are magnified proportionally.

Here are two real-world examples. One fund is by far the largest actively managed equity fund in the world, a $75 billion fund that finally closed its doors to new individual shareholders in 1997, when assets stood at $60 billion, all the while leaving the doors wide open to its millions of existing retirement plan investors. In five of its largest equity positions, it held a total of 40 million shares. But just 10 of the sister funds supervised by its management company owned nearly 130 million shares. To the extent that the remainder of this giant fund’s portfolio duplicates this ratio, it’s fair to say that the fund (sort of ) closed its doors at an asset level, not of $60 billion, but effectively an asset level of $200 billion. That decision, if you believe the press releases, passes for discipline in this industry.

Another example is the second largest actively managed equity fund, with assets of $47 billion. Along with just two sister funds managed by the same firm (the fourth largest equity fund, with $45 billion, and the 32nd largest, with a mere $10 billion), five of its largest portfolio holdings represent one-third of the shares owned by three funds in aggregate. If we assume that this ratio approximates the relationship between its entire portfolio and all of the other fund and institutional accounts managed by the firm, this fund’s effective size is $105 billion, with all of the constraints that implies. And yet none of the funds (or managed accounts) in this complex has yet been closed to the flow of new money.

It seems clear that funds that have created a record of remarkable returns at relatively small asset levels have a pronounced tendency to lose that edge when they get large. There is also considerable anecdotal evidence that highly volatile funds that have been successful tend to become far less volatile when they get large. In either case, whatever utility a fund’s past record of performance may have had becomes completely irrelevant as giant size takes hold. Surely shareholders should be made aware of the extent to which these circumstances exist, for they relate directly to the validity, viability, and relevance of the long-term records that are presented in fund promotional material as gospel. “Past performance does not guarantee future returns,” the customary industry boilerplate, is but a pale recognition of this phenomenon.

TEN YEARS LATER

Real Size, Real Problems

The pattern shown in Figure 12.4 continued during the period since 1998. The assets of those five funds largely held steady through 2003, only to decline with the two bear markets that followed. But their returns—beating the S&P 500 when they were small, quickly leveling off, and then producing subpar returns during the mid and late 1990s—remained ho-hum during the past decade—trailing the index in four years, tracking the index in another four years, and winning in only two years—one more iteration of the RTM described in Chapter 10.

What’s Size Got to Do with It?

There are three major reasons why large size inhibits the achievement of superior returns: the universe of stocks available for a fund’s portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured, group-oriented, and less reliant on savvy individuals.

A Shrinking Universe

The shrinking universe of investment opportunities that comes with size is quite obvious. There are legal and practical constraints on security ownership. To ensure broad diversification, managers rarely wish to have their funds hold many investment positions in excess of 3 percent of fund assets. Further, because dominant ownership positions may well constrain market liquidity as shares are purchased and sold, only a rare firm will wish to have very many positions representing as much as 10 percent of a corporation’s shares outstanding.

Taken together, these two limitations—on diversifying assets and on maintaining liquidity—have a clearly calculable relationship to the number of major portfolio positions that can be held at a given level of fund assets. For example, assuming a 2 percent maximum holding and a 10 percent maximum ownership, a manager of a $1 billion portfolio in mid-1988 would be able to choose from among 3,080 stocks (see Figure 12.5). But if the portfolio were $5 billion, the number would be 1,272 stocks, a drop of more than half. At $20 billion, it would drop by nearly two-thirds, to 470 stocks. And if the constraint on ownership engendered by the risk of illiquidity were 5 percent of a company’s shares outstanding (probably, given industry practice, a more realistic figure than 10 percent), only 257 issues would be available. This net reduction of 92 percent from the original number entails limitations on portfolio selection that are as important as they are obvious.

FIGURE 12.5 Universe of Stocks Available to Purchase (1999)

TEN YEARS LATER FIGURE 12.5 Universe of Stocks Available to Purchase (2009)

The manager of a large portfolio could try to escape some of the problems of size by having larger numbers of holdings in smaller concentrations. (The largest fund, for example, owns 483 stocks.) But the performance of each holding, by definition, would have a smaller impact on the performance of the portfolio. Also, the manager could structure a strategy around industry subsets such as Internet participants, modem manufacturers, circuit board makers, and so on, rather than pick individual stocks. But the fundamental point remains intact: Large asset size reduces drastically the number of important portfolio positions that can be included in the investable universe available to a portfolio manager of a large fund.

TEN YEARS LATER

A Shrinking Universe

The number of stocks available for purchase by a mutual fund, to state the obvious, shrinks as fund assets grow. Using the same set of assumptions as in the previous edition, Figure 12.5 looks pretty much like its predecessor despite substantial changes in the market capitalizations of individual stocks. A $1 billion fund has approximately 2,500 stocks available for purchase at a significant portfolio weight, while a $20 billion fund (there are now 23 actively managed equity funds with assets of at least $20 billion) has only about 440 potential buying opportunities.

But even this limit may be far too high. Why? Because, as I wrote earlier, individual funds are part of giant fund complexes that often manage not only many other large funds but giant pension plans as well. One of the largest equity fund managers, for example, owns 127 million shares of Microsoft in its largest fund, but another 150 million shares in its other funds, and an additional 255 million shares in the pension accounts that it manages—in all, 532 million shares, fully 6 percent of Microsoft shares outstanding.

Higher Transaction Costs

A second factor is that the cost of portfolio transactions increases with size. As a general rule, managers could do far worse than reciting, “The larger the number of shares traded, the greater the impact on price,” and quickly adding, “The higher the percentage of a day’s (or week’s) volume, the greater still the price impact,” followed by, “The greater the urgency to complete a transaction, the greater again the price impact.” These general conclusions would then follow: (1) short-term strategies are more costly to implement than long-term strategies; (2) momentum trades are more costly than trades based on fundamentals; (3) information-sensitive trades (based on purported market knowledge) are more costly than informationless trades (i.e., index fund transactions); and (4) aggressive trades made with speedy execution as the goal are more costly than opportunistic (contrarian) trades.

Mutual fund size, as such, is not the problem. No transaction costs are associated with the huge long-term holdings of American Express, Walt Disney, and Gillette owned by Mr. Buffett ’s Berkshire Hathaway—even though those positions represent, on average, fully one-half of those of the entire mutual fund industry—or of Coca-Cola, in which his 200 million shares are almost double the 112 million shares held by all funds combined. (Now we see how funds can be so underrepresented in Coke!) Why? Because he doesn’t buy or sell them very often. The shares of Berkshire Hathaway aren’t redeemable on demand, so he won’t need to sell them until he wishes to do so—at his price (i.e., opportunistically). If he should want to get out in a rush, he would doubtless have to accept a considerable price sacrifice. But that is hardly his style.

“A Fat Wallet Is the Enemy of Superior Investment Results”

Asset size is an issue for all investment institutions that manage huge accumulations of capital. The statistical evidence is quite convincing. Truly outstanding managers have become an endangered species. In a 1998 article entitled “Where, Oh Where, Are the .400 Hitters of Yesteryear?”¹ portfolio strategist Peter L. Bernstein found strong evidence that the margin of outperformance of the most successful investment managers (including mutual fund managers) has been steadily shrinking over the past 40 years.

His statistical study struck a responsive chord with Warren E. Buffett, quoted above, who expressed the view that the culprit of the trend toward mediocrity was asset size rather than heightened competition for winning performance, as Mr. Bernstein had suggested. Mr. Buffett said that “about 75 percent of the difference in our performance between now and in the distant past is accounted for by size. We have always known that huge increases in managed funds would dramatically diminish our universe of investment choices. [The Berkshire Hathaway assets he supervises now total $64 billion.] Obviously performance would be much diminished if we had only 100 securities available for possible purchase compared to, say, the 10,000 available when our capital was microscopic.”²

Here is how he described what happens to performance when the portfolio wallet fattens: “For the entire 1950s, my personal returns using equities with a market cap of less than $10 million were better than 60 percent annually. At our present size, I dream at night about 300 basis points” (i.e., 3 percentage points per year better than the market).

The mutual fund industry has been facing the same issues of size as has Mr. Buffett for at least a decade. But the giant fund firms are hardly as candid as Mr. Buffett in articulating the challenges of “a fat wallet,” let alone acknowledging the constraints that large accumulations of assets impose on earning superior returns.

I have heard of only one manager in the mutual fund industry who has examined the impact of trading costs—commissions, bid-ask spreads, market impact, opportunity cost—in his own firm, and has had the courage to make the results public. He is John C. Bogle Jr., portfolio manager for the three mutual funds of Numeric Investors—all quantitatively run, high-turnover accounts. (Full disclosure requires me to note that he is my oldest son. Apparently, the apple doesn’t fall very far from the tree.) After examining more than 20,000 trades, he reports these costs: trades in value stocks, 0.6 percent of the dollar amount of the trade; trades in small-growth stocks, 1.8 percent; trades in which shares represent one-eighth of daily volume, 0.5 percent; shares representing two days’ volume, 2.3 percent. He concludes that the hidden drag of transaction costs rises as the size of purchases and sales becomes a larger fraction of market volume—an effect that, he states, “exists for every style, for every size, and for every manager.” He recently closed two of his three funds at asset levels of $100 million each. That is discipline.

More universally, based on data provided by the Plexus Group, typical total trading costs for an investment manager are estimated to be about 0.8 percent of the amount of transaction value. If a fund has a turnover of 50 percent per year (in effect selling one-half of the stocks in the portfolio and then reinvesting the proceeds in other stocks), purchases and sales together would be equal to the fund’s average assets. Thus, the fund’s annual return would have been reduced by 0.8 percent, or 8 percent of an assumed 10 percent return. At 100 percent turnover, the annual performance penalty—other factors held constant—would be 1.6 percent. These hidden transaction costs, added to the expense ratio of 1.5 percent for the average equity fund, would create an aggregate fiscal drag of more than 3 percent per year—consuming almost one-third of a 10 percent annual return.

My own estimates of industry-wide transaction costs are well below these figures, which vary with investment objective, style, transaction activity, and fund size. But there seems little question that transaction costs have some direct correlation with asset size. Smart managers—and most fund managers are smart—have to be particularly alert when the assets they manage increase relative to the market. The managers must add some sort of value that exceeds their growing transaction costs. If they can’t get smart—and as individuals in a group they can never all outsmart each other—they must fall further behind the cost-free returns earned on unmanaged market indexes composed of securities similar to those represented by the fund’s style. The evidence strongly suggests that no extra value has been forthcoming.

The Triumph of Process over Judgment

The third reason that large size impairs outstanding returns is less obvious. But the handicap it imposes on the managers of a fund organization is no less real. As an organization expands, the impact of an individual portfolio manager wanes, and the impact of an institutional investment process waxes. No longer are there a few portfolio managers with messy desks, bright ideas, and decisive minds, supported by a handful of analysts and traders, and modest administrative backing. Now, there is a horde of funds (as many as 100 or more), plus an organization chart, an investment process, committees to approve transactions and then to appraise them, meetings, exhaustive legal and regulatory filings, red tape, and a focus on process (“Who’s in charge here?”) rather than on judgment (“What should we own?”). The manager who used to invest heavily in his best ideas can no longer afford to do so.

Wall Street Journal columnist Roger Lowenstein is one of the few journalists who has recognized this phenomenon. He recently wrote: “Picking stocks, like writing stories, is a one-at-a-time endeavor. It is done best by individuals or small groups of people sharing their ideas and buying only the very best. A small fund family managing selective portfolios . . . can succeed as a group, but no large institution . . . can order dozens of managers to outperform. The image can be branded, but not the talent. The people matter more than the name.”³

Nothing Does Succeed Like Success—for Fund Managers

My hypothesis that “nothing fails like success” has been laid out before you. To show why it must be so, I’ve presented compelling evidence based not only on common sense but on statistics. My reasoning is hardly counterintuitive. Given the industry’s present size (which seems rather unlikely to shrink back to where it was a decade or even five years ago) and its growth rate, the problems connected with giant size are far more likely to intensify than abate. Is it not significant that no one—as far as I know—has ever seriously presented the converse case? No financial journal has published a paper entitled, in essence, “Asset Size: Remarkable Benefits to Mutual Fund Investors.” No member of the personal finance press has advised, “For Truly Superior Performance, Go with the Giants,” nor offered a defense that meets a lower standard: “Large Funds: The Easiest Way to Beat the Indexes.” Probably the most favorable comment a manager of any large portfolio would dare make on the subject is: “Size doesn’t significantly impair my ability to do my job.” But I’ m not at all sure that it would be said with much enthusiasm or conviction, or even with a straight face. To me, the case that asset size (a fat wallet, in Warren Buffett’s words) is the enemy of performance excellence is so obvious that it defies serious debate.

Why do funds allow size to get out of hand? Because, for advisers, “nothing does succeed like success.” The management company loves large size because the dollar amount of the advisory fees it receives rises almost linearly with fund assets. The larger the assets, the larger the fees. And the management company’s profits grow at a still higher rate, even as returns to fund shareholders are impaired. Why? Because the huge leverage of economies of scale has been arrogated by advisers to their own benefit rather than to the benefit of the fund shareholders they serve.

The industry is growing apace, largely because American investors, excited by the continuing bull market, have developed an appetite for mutual funds that seems virtually insatiable. Individual fund complexes are growing at a parallel rate. Their growth is not only accepted, but is being accelerated by aggressive marketing campaigns, often at the expense of the investors who own the fund. The chief catalysts are fund advisers who have everything to gain, financially speaking, and nothing to lose by building funds to such a size that their past performance is irrelevant and their future performance is destined for mediocrity: the return of the market, reduced by the fund’s management fees and transaction costs.

To Dream the Impossible Dream

Mutual fund investors owe it to themselves not only to be aware of the problems of burgeoning size in an industry that seems to applaud giant fund complexes, but also to become a force in their resolution. Albert Einstein said, “Any intelligent fool can make things bigger, more complex . . . it takes a touch of genius—and a lot of courage—to move in the opposite direction.” It may be an impossible dream, but there are some decidedly real-world solutions, some rules that managers can follow, if only they are given the incentive to do so. If enough investors demand change and “vote with their feet” by selecting funds that follow these rules, and by moving their investments out of funds that ignore them, progress will come. Here, then, are the imperatives that would be followed by wise and responsible fund managers:

1. Change the fund’s strategy, but not its objectives. Whatever happened to long-term strategy? From less than 20 percent in the good old days, fund portfolio turnover has increased to nearly 90 percent per year. Whatever else it may have accomplished, it has not improved fund returns relative to the market. In fact, fund returns have arguably deteriorated. Why don’t the leopards of the mutual fund industry change their spots and go back to those good old days? (Returning to the industry’s traditional 15 percent turnover rate might be even better.) I imagine the answer is: Most managers prefer to be short-term traders (today’s average holding period is roughly one year) rather than long-term investors (if an average holding period of seven years, which would reflect a 15 percent turnover, is sufficient to qualify for that description).

The present situation, however, is likely to persist. First, because the new breed of portfolio manager likes turnover. Perhaps these managers are aggressive by temperament. They’ re highly intelligent and well educated, and they want to apply their talents, such as they may be, actively and often. Second, and perhaps even more important, managers in this industry make the big money if they can deliver flashy short-term fund performance. A steady-as-you-go, buy-and-hold portfolio has become an anachronism. The way to garner assets for a new fund is to build a record the financial press will write about. The money then flows in, leading to soaring advisory fees and strong profits for the managers. No one worries much that the fund’s character (and its performance) must change when it grows large. The attitude seems to be, “We’ll worry about that tomorrow.”

2. Close the fund to new investors. When a fund reaches a size at which it can no longer implement its strategy because of a constricting number of stocks in its universe, or because of the increasing likelihood of significantly influencing prices through active buying and selling, why not close the fund? So far, even as the problems of dealing with size have become imminent, only about two out of every 100 funds have closed, including a few that have done so at far higher asset levels than would seem appropriate. But most funds seem to ignore the problem and so face deteriorating relative returns and reduced opportunities to distinguish themselves, to the detriment of shareholders who purchased their shares because the fund had distinguished itself in the past. As John C. Bogle Jr. has said, “Managers and trustees have turned a blind eye toward the interest of the shareholder, in favor of their own interest in the ever growing stream of revenues.”

Sad to say, the status quo seems likely to persist simply because the profitability of a fund “franchise” to the manager is linear: The larger the fund, the larger the return to the adviser. This incentive seems to supersede any interest in providing the optimal return to the shareholder. If investors and financial advisers were to place their investment heft behind the fair resolution of this issue, and if the financial press were to give it the attention it deserves, fund managers might finally be forced to act and close funds at appropriate levels.

3. Let the fund grow, but add new managers. One obvious solution to the problem created when a fund begins to get too large to implement its earlier strategies is to bring in a new portfolio manager and allocate part of the existing portfolio and future cash inflow to the new firm. (I recommend a new firm because bringing in a new manager from the existing firm would not solve the liquidity problem.) However, only a few large fund groups have used multimanager structures, assigning two to four external managers to supervise an existing fund. Given the true arm’s-length negotiations that are implicit under this arrangement, advisory fees paid to the new external advisers are apt to be far below industry norms. This situation presents the paradox of why the in-house adviser for a given fund receives a high fee, but an external adviser for a sister fund receives a fee a fraction as large. (Investors should raise that question with their fund’s management or its directors. I’d love to hear the answer.)

The retention of an external manager comes to grips with the size issue by allowing a fund to grow without the loss of—and perhaps with an increase in—investment efficiency. However, the solution also creates a new problem. How likely is it that the portfolio run by the new adviser will add value? Won’t two managers simply offset each other with inevitably alternating periods of good and bad returns? What about four managers? Or six? There is clearly a law of diminishing returns, and it may begin to come into play as early as the addition of the first manager. We just can’t be sure. In any event, use of this strategy is rare.

4. Lower the basic advisory fee, but add an incentive fee. If the goal is to maintain a generous incentive for the manager without jeopardizing the relative returns to the investor, why not cut the regular fee and add an incentive that is paid only to the extent that the fund’s returns exceed the returns of an appropriate market index? A simple example: Cut the fee from 1.00 percent to 0.75 percent, and add an incentive of 0.25 percent. The problem (for the manager) is that the incentive must be symmetrical. A fee penalty of 0.25 percent would be imposed if the fund falls short, in which case the total fee would tumble to 0.50 percent. But fair is fair. Do the job and get paid; fail and take the consequences. Or fairer yet, make the standard, not the index return, but the index return plus the margin of excess return over the index that the fund had achieved in, say, the prior five years. This is likely to be the performance the shareholders are expecting, and the mutual equity of such a structure seems quite obvious.

Alas, these two types of incentive fee solutions (especially the second one) seem unlikely to be adopted unless fund shareholders demand their implementation. Basic incentive fees, never common in this business, are becoming even more rare. Barely 100 of 7,000 mutual funds now make use of them. Managers would rather receive something (a high fee) for nothing (the fee is paid whether performance is good or bad). Nonetheless, any challenge to the existing fee culture of the industry is conspicuous only by its absence.

5. Offer a mutual fund that is size-proof, with minimal turnover and a nominal fee. Given the evidence of the importance of transaction costs and management fees in shaping past returns and the fact that the huge present size of the industry, combined with the higher level of fees, may make the attainment of even the present standard of mediocrity more difficult to attain in the future, wouldn’t a low-turnover, low-cost fund provide a solid alternative for mutual fund investors? Of course it would. But “long-term investing” seems to have vanished from the lexicon of most portfolio managers, in part because it is apparently difficult to identify first-class enterprises that will have staying power and in part because most of today’s managers are an active, impatient lot. Taking this rule to its logical conclusion suggests an index fund, but an index strategy, while it clearly provides superior profits to investors, provides minuscule profits to the advisers.

You Can Make the Dream a Reality

Rare indeed is the fund organization that has taken any of the preceding suggestions very seriously—so far. Portfolio turnover is high and shows no sign of diminishing, despite some fragile evidence that unit transaction costs are rising. Few funds have closed, and many of those that have closed have done so far later than their growth demanded. The use of external managers is as rare as 10-carat diamonds. Expense ratios are rising, most notably for the horde of new funds being formed. Incentive fees not only remain conspicuous by their rarity, but are indeed being abandoned. Fund innovation—in other areas, clever to a fault—has ignored the opportunity to create funds that are more cost - efficient and more tax—efficient. (I present one structure for such a fund in the next chapter.) The best existing proxy for dealing with the challenges of large size—the index fund—is a pariah that is accepted largely because trustees of institutional thrift and retirement plans (which, paradoxically, gain no performance advantage from tax efficiency) are demanding it for corporate employees. As fund investors, you are among the 50 million Davids who, together, can hurl a rock that will get the attention of the Goliath fund management companies and stun them into recognizing the problems of asset size.

Compared to its beginnings, the mutual fund industry today is different in the aggregate, different in its power in the financial markets, different in its investment limitations, different in its costs and its impact on the stock market, and different in the way its investment decisions are made and implemented. Any reliance on history as a guide to the future accomplishments of individual mutual funds, and of the fund industry itself, is tenuous at best.

If present growth rates continue, in only a few years, mutual fund managers could control perhaps four—tenths of all U.S. equities and account for as much as three-fourths of all equity transactions. Why isn’t the industry more forthright about the issue of size? Why can’t we face up to the fact that our burgeoning asset growth has already changed the character of most giant funds, and indeed, of the industry in the aggregate? Liquidity matters. Cost matters. Taxes matter. And size can kill. The challenge of performance excellence is becoming more formidable and more impregnable to attainment, even by skilled professional portfolio managers. If funds won’t deal with these questions, investors must persist in raising them. If left unresolved, their impact on funds’ performance and future returns may be profound.

No firm—I repeat, no firm—is exempt from these issues, and hence no fund investor is exempt. Investment firms and investors alike must have the wisdom to face this dissonant music. The mutual fund industry’s fabulous success is living proof that “nothing succeeds like success.” But that rule may well be sowing the seeds of its own antithesis: “Nothing fails like success.” Investors must consider all of the implications of investment size, not only for the funds whose shares they own, but for the industry colossus they have helped to create.

TEN YEARS LATER

The Impossible Dream

Most of my dreams about dealing with the problems of giant- ism in fund asset size proved to be “impossible dreams.” My hope that fund size would lead to lower turnover died aborning. (Turnover in 2009 is even higher than in 1998.) Closing funds to new investors remains a rarity. (It demands not only consider able discipline by fund managers, but also a willingness to act in the interest of shareholders rather than their own self-interest.) And I know of not a single fund manager that has significantly lowered its basic advisory fee, replacing the lowered amount with an incentive fee based on actually earning superior returns for its shareholders. (Could it be that such incentive fees require performance that ultimately is impossible to deliver?)

My idea of multimanager funds has gained some traction, but largely because a single firm has incorporated this tactic as part of a strategy of diversifying to the nth degree, focusing on long-term investing, and negotiating minimal fees (and not in the expectation that picking four to six consistently superior managers is realistically possible). And while the size-proof low-turnover index funds I endorse have indeed come into their own, their growth has come largely by attracting investors who buy and sell with stunning alacrity, using exchange-traded funds (ETFs) as their vehicles.

While the fund industry has yet to face up to the issue of asset size, it remains true that “size can kill.” That problem is as relevant in 2009 as it was in 1999—indeed, even more relevant. It continues to be the responsibility of the fund investor to carefully consider the problems created by giant fund size, and to avoid being trapped by them.