Are big funds nearing a limit?
Popularity often is the kiss of death for an investment. When too much money chases the same thing, that thing usually is on a fast track to becoming overvalued and, ultimately, a lousy 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, Fidelity Investments and Davis Funds, have gone from big to much bigger, while still in many cases outperforming smaller funds that in theory ought to be more nimble.
Case in point: 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, becoming by far the largest stock fund.
Despite that torrent of new money, Growth Fund last year earned a total return of 10.9%, 4 percentage points better than the average fund that focuses on large-company growth stocks, according to research firm Morningstar Inc.
Over the last five years, Growth Fund’s average annualized return was 8%, compared with 2.9% for the typical fund in its category. It also beat the blue-chip Standard & Poor’s 500 index, which was up 6.2% a year.
American Funds and its mega-fund peers, all veteran money management firms, get high marks from Morningstar for their stock-picking prowess.
Even so, there’s an element of sheer momentum helping these funds as well. As their returns rise, more investors are drawn to them. As money flows in, the fund managers may in part just add to stocks they already own, further boosting their returns -- and attracting more investors.
Sound familiar? That kind of momentum helped drive the technology stock juggernaut in the late 1990s.
This time around, the funds with momentum are broadly diversified rather than focused on one industry niche. And the stocks they favor tend to be the world’s blue chips, not dot-com start-ups. That should give investors a higher comfort level about the mega-funds.
Still, 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 portfolio manager, or team of managers, can take on before either running out of good ideas or owning so many securities that the fund just mimics market indexes, or worse.
That question has been raised many times before. It dogged legendary stock picker Peter Lynch in the 1980s as his fund, Fidelity Magellan, swelled from $18 million to $14 billion in assets. Almost all the while, Magellan’s performance remained stellar under Lynch, who retired in 1990.
Lynch’s $14 billion of that era, however, looks modest 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 $66 billion.
Investors in the giant funds are living “a very interesting experiment right now,” says Roy Weitz, who runs the FundAlarm industry watchdog website.
The size question is asked most often about the American Funds portfolios because of the company’s unusual fund management approach.
Most major fund companies offer scores or even hundreds of individual funds. American Funds, owned by Capital Group Cos., has become the largest U.S.-based stock and bond fund manager, with nearly $1 trillion in assets. And that money is spread across just 30 funds in all.
Paul Haaga, executive vice president of Capital Group’s fund management arm, says the company’s philosophy has always been that good stock picking doesn’t need to be packaged and sold like myriad flavors of candy. The firm stresses the basics: Find good companies, try to buy the stocks when they’re cheap, and hold for the long haul.
And with a limited number of funds, the American Funds portfolios benefit from economies of scale. That means low management expenses for shareholders.
As for the hands-on management of its funds, 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 a fund’s team.
Paul Herbert, an analyst at Morningstar in Chicago who tracks American Funds, says that despite the firm’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 says.
Last year, through November, four of the nation’s top five stock funds by net new investment money were in the American Funds group, according to Financial Research Corp. American Funds has had the largest cash inflows of any fund firm every year since 2003.
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 trick of sorts. Fund companies sometimes close a portfolio, then quickly open a clone that makes similar investments -- but with higher fund management fees.
And for the biggest funds today, it isn’t practical to completely close the door because many people invest through their 401(k) retirement savings plans. It’s hardly fair for a fund company to tell 401(k) investors, who typically have limited plan options, that one or more of those options is no longer available.
Capital Group believes it has a better idea than closing the door, Haaga says: Any of its portfolio managers can say they don’t want more money. When that happens, the multiple-manager system allows for cash coming into a fund to be directed to other managers who have investments they want to pursue.
In a sense, Haaga says, “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 worldwide in this decade. That has been a turnabout from the late 1990s, when growth stocks (shares of companies whose earnings are expected to grow faster than average) led that era’s bull market.
Many of the current fund giants tilt toward value stocks in industries such as energy, utilities and financial services. Even American Funds’ growth portfolios tend to be more value-oriented than their industry peers.
The big test ahead for the mega-funds is how investors react when value stocks finally stall out. If too many investors flee the funds because performance begins to wane, they could wreak havoc with the portfolios by forcing managers to dump stocks.
That’s what ruined many growth-stock funds in the 2000-02 bear market.
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.
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Popular portfolios
Here are the stock mutual funds that had the largest net cash inflows last year.
Net cash inflow, Jan.-Nov.
(In billions)
Growth Fund of America*: $17.6
Capital World Growth & Income*: $14.2
Dodge & Cox International: $10.9
Capital Income Builder*: $10.9
EuroPacific Growth*: $10.5
Vanguard Total Stock Market index: $8.7
iShares MSCI-EAFE index**: $6.1
Fidelity Diversified International: $5.7
Fundamental Investors*: $4.9
Franklin Income: $4.7
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*Managed by American Funds group
**Broad foreign stock market index fund
Source: Financial Research Corp.
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Tracking the giants
Performance data for some of the biggest U.S. stock mutual funds by Morningstar category:
*--* Assets Annualized total returns: (billions) 2006 5 yrs. 10 yrs. Large-cap U.S. growth American: Growth Fund $160 10.9% 8.0% 12.9% of Amer. American: AMCAP 25 8.6 6.1 11.0 Category average 6.9 2.9 5.9 Large-cap U.S. value American: Invest. Co. 89 15.9 8.0 10.5 of America American: Washington 84 18.0 7.6 9.9 Mutual Category average 18.1 8.3 8.8 Large-cap U.S. blend American: Fundamental 38 19.2 10.6 11.1 Investors Vanguard Total Stock 77 15.5 NA NA Market index Davis New York Venture 44 15.1 9.4 10.6 Category average 14.1 5.9 7.8 Foreign large-cap value Dodge & Cox 31 28.0 20.8 NA International Category average 26.0 16.5 10.7
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