Giant funds post big returns, but may contain some risks

Los Angeles Times columnist

Popularity often is the kiss of death for an investment.

Yet some of the nation's largest mutual funds have generated great returns for their investors in recent years even as a massive wave of fresh cash has poured in.

These funds, managed by firms including American Funds, Dodge & Cox and Davis Funds, have rewarded investors who have stayed aboard rather than seeking out smaller, less-well-known portfolios.

The biggest case in point: the Growth Fund of America, part of the Los Angeles-based American Funds group, has swelled from $36 billion in assets in 2002 to about $160 billion now, making it by far the largest stock fund.

Despite that torrent of new money, Growth Fund last year earned a total return of 10.9 percent, four percentage points better than the average fund that focuses on large-company growth stocks, according to Morningstar Inc.

American Funds and its mega-fund peers, all veteran money management firms, receive high marks from Morningstar for their stock-picking prowess.

Even so, there's an element of sheer momentum helping these funds. As their returns rise, more investors are attracted to them. As money flows in, the fund managers may in part just add to stocks they already own, further boosting their returns--and piquing more investors' interest.

Whatever the combination of skill and luck, as these already-huge portfolios continue to balloon, some fund industry analysts worry about a day of reckoning.

One issue is whether there simply is a limit to the amount of money that any single portfolio manager, or team of managers, can take on before they run out of good ideas.

That question has been raised many times before--it dogged legendary stock picker Peter Lynch in the 1980s as his fund, Fidelity Magellan, swelled to $14 billion from $18 million.

Lynch's $14 billion, however, looks like a modest sum compared with what the modern mega-funds hold. Davis New York Venture Fund has $44 billion in assets; Fidelity Diversified International holds $47 billion; Dodge & Cox Stock has $65 billion.

The size question is asked most often about the American Funds portfolios.

Most major fund companies offer scores or even hundreds of individual funds. American Funds, owned by Capital Group Cos., has just 30 funds in all.

Paul Haaga, executive vice president of Capital's fund-management arm, said the company's philosophy always has been that good stock picking doesn't need to be packaged and sold like myriad flavors of candy. The firm stresses the fundamentals: Find good companies, try to buy the stocks when they're cheap, and hold for the long haul.

As for the hands-on management, Capital Group employs a team approach: Each fund is divided into slices that are individually managed by Capital Group "portfolio counselors."

Growth Fund of America, for example, has 10 managers. The firm's second-largest fund, the $95 billion EuroPacific Growth fund, has eight managers.

Capital Group has long maintained that its approach means there's no risk of a fund becoming too big to manage. As assets grow, so does the team.

Paul Herbert, an analyst at Morningstar who tracks American Funds, said that despite the company's approach, he'd feel better if Capital Group considered closing some of its biggest funds to new investors.

"I'm still worried that the funds' continued growth will end up eroding their performance records," to the detriment of current shareholders, he said.

Many fund companies have closed popular funds, at least temporarily, in recent decades when money has poured into particular market niches.

But closing a fund also can be a marketing ploy. Fund companies sometimes close a portfolio, then quickly open a clone that proposes to make similar investments--but with higher fund management fees.

Capital Group has a better idea, Haaga said: Any of its portfolio managers can say they don't want to take on new money. When that happens, the multiple-manager system allows for cash to be directed to other managers who have investments they want to pursue.

In a sense, Haaga said, "We close portfolios all the time," without closing an entire fund.

Even if they aren't weighed down by their size, the star mega-funds of the last few years could face another performance challenge: Their "value" investing theme could go out of style.

Value stocks--shares that appear cheap relative to earnings and other measures--have been the market leaders in this decade. That has been a dramatic switch from the late-1990s, when growth stocks (shares of companies whose earnings are expected to grow faster than average) led.

Many of the current fund giants tilt toward value.

The big test that lies ahead for the mega-funds is how investors react when value stocks finally stall out. If too many investors flee because of poor performance, they could wreak havoc with the portfolios by forcing managers to dump stocks.

Value investors often are considered to be less fickle than growth investors, but so many people have come into the value camp since 2000, their staying power has to be a question mark.

Tom Petruno is a columnist for the Los Angeles Times, a Tribune Co. newspaper.

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