How Funds Manage Boatloads of Money
Fund providers are paid a percentage of the assets they hold as a management fee, so managing more assets is better for them. But is it better for you, the shareholder?
It is if you own an index fund, a generic vehicle for which bigger is almost always cheaper and better. But investors in actively managed portfolios that experience large or rapid inflows may suffer for it.
Although an increase in assets will probably produce economies of scale for actively managed funds, too — running twice as much money is not twice as expensive — it can also result in higher trading costs. That could prompt managers to change tactics in counterproductive ways.
“If a manager gets a lot of new money, that’s putting pressure on them,” said Russel Kinnel, director of manager research at Morningstar. “One option is to keep doing what you’re doing and accept higher trading costs.”
Another, Mr. Kinnel said, is to gravitate toward larger companies than a fund might ordinarily own, or to “add holdings or trade less.” For a fund manager, that would entail “choosing between various alterations to your strategy or accepting higher trading costs, or some combination,” he said. Many factors go into determining performance, and whatever managers choose to do, there is no way to tell where they would have ended up by taking a different path.
Adding positions can mean making investments that managers might otherwise have considered unworthy. Trading less can tie their hands and impede their judgment. Buying larger companies, whose commercial fortunes can turn on dynamics different from those that affect smaller businesses, may require acumen that a manager with a limited perspective lacks.
“Managers have this image of success, then when they get there they want more,” said Jack Chee, a senior research analyst at Litman Gregory Asset Management, a provider of investment advice and research. “They start running more names, go from small- to mid-cap, increase their analyst team.” The days of excelling with one strategy, he added, were largely over.
The benefits that accrue to investors when an actively managed fund accumulates assets may not be great. Unlike index funds, which are simpler, more transparent and compete largely on price, actively managed funds may not pass on all, or even most, of their savings.
Mr. Kinnel gives Vanguard top marks for sharing the spoils — in its actively managed funds and its index funds — with honorable mentions going to T. Rowe Price and Capital Group’s American Funds.
“Almost every firm has a slightly different way of pricing things,” he said. “If Vanguard is giving you all of the economies of scale, Capital Group is giving you most of them,” while Pimco “is kind of a mixed bag,” with retail funds that “tend to be pricey.”
At the other end of the spectrum, Mr. Kinnel said, Oppenheimer International Small-Mid Company, which closed to new investors last year, raised its management fee 20 percent and broadened its investment universe to include midsize companies (its name was changed from Oppenheimer International Small Company).
Investors, he said, had gotten “the worst of all worlds.”
Kimberly Weinrick, an OppenheimerFunds spokeswoman, attributed the fee increase to higher expenses for the fund and said it had been priced lower than similar funds. She also said the portfolio had always included midsize stocks and drew attention to its strong long-term performance. She noted that the fund had received a five-star rating from Morningstar.
It may seem odd that coping with large capital inflows is a problem, given that certain categories of funds have suffered from the opposite predicament. Actively managed domestic stock funds had $243 billion in net outflows in the 12 months through July, according to Morningstar, overwhelmingly because of a migration to index funds that Mr. Chee called “Flowmageddon.”
That broad trend is at odds with the challenge that unwieldy inflows present to many individual portfolios. It can become so acute that a fund must slam the door on new investors.
In early October there were 415 funds, with total assets of $1.38 trillion, that have taken this step, Morningstar said. Some of the so-called soft closings date to the 1990s, but 72 funds, with assets totaling about $104 billion, have done it this year, or nearly one-fifth of all such funds.
Funds that have more than $10 billion under management and have closed to new investors in the past couple of years include American Century Equity Income, Artisan International Investor, Delaware Value and Vanguard Dividend Growth.
Fund providers sometimes avoid restricting access when inflows become unwieldy because a smaller asset base means less in fees, as well as fewer shareholders to share in the taxes that must be paid on distributed capital gains each year.
Mr. Chee said he preferred funds that had shown a willingness to close to new investors or that had smaller asset bases. He offered William Blair, FPA Funds, FMI Funds and Nuance Investments as examples
Attitudes toward soft closings differ among giant fund providers. Tim Cohen, head of global equity research at Fidelity, said his company had “a history of funds going through rapid asset growth and closing them when we thought there would be a problem managing assets coming in.” Fidelity has closed 21 funds to new investors, including three this year, according to Morningstar.
Other measures that Fidelity has taken in advance to avoid missteps because of rapid inflows include expressing investment objectives clearly in prospectuses and compensating managers based solely on performance, not on asset growth, Mr. Cohen said.
Companies like Vanguard would rather find new managers than lose investors. The management of many of the actively managed Vanguard portfolios is done by outside firms, so that if the assets in one portfolio grow too large for the existing stable of managers, it is always possible to saddle up another horse.
“We would rather find a second manager to hold 60 to 80 stocks” than have an existing manager add holdings, said Daniel Newhall, head of oversight and manager search at Vanguard.
Adding managers along with assets allows investors to enjoy the benefits of scale without enduring the drawbacks, Mr. Newhall said. Returns tend to improve when multiple managers provide their best individual selections, perhaps via disparate methods, compared with a single manager picking the same number of securities, he said.
To determine whether a fund may be facing difficulty managing inflows, Mr. Chee said he encouraged investors to ask whether managers had begun to buy stocks they might not otherwise own to avoid larger positions in existing holdings.
“Managers at best only have two handfuls of truly great ideas,” he said. “Once you get to 30, you go from great ideas to good ideas.”
Mr. Kinnel said that in general he liked fund providers that indicated early on that they had a plan to avoid gathering assets beyond a certain point, even if the plan was to close to new investors.
“What you don’t want to hear is a manager who says, ‘It’s not a problem now; if it becomes one, we’ll close it,’” he said. “Then it’s too late.”