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Drawing the Line on Asset Bloat Continued From Cover

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returns are a nifty 11 . 4% annualized—a hair better than either Franklin fund.

billion from $ 6 billion in just two years, manager Bruce Berkowitz argued that the added heft enabled him to get a seat at the table and do bigger deals than he could do before. However, what he hadn’t bargained for was just how quickly those assets could leave. When a fund has amazing returns and stays open, it can get some very hot money. Hot money chases the very best performers and thus is prone to leave at the first downturn. When everyone runs for the door, it can cause huge headaches way beyond the challenge of mere asset bloat. That’s what happened when Fairholme had a terrible 2011 . Heavy redemptions meant Berkowitz had to sell stocks he didn’t want to, and it dropped the fund’s cash position lower than he wanted it. These things in turn made performance worse. A chastened Berkowitz later closed the fund in the hopes of keeping hot money out. It’s a good reminder that, in an open-end fund, it matters who your fellow shareholders are. Asset bloat is sneaky because it is rare that it is the main driver of a fund’s single-year performance. Asset bloat can be a handicap, but a bad year doesn’t prove its existence, just as a good year doesn’t prove it doesn’t exist. For example, both Fidelity Magellan FMAGX and Fidelity Contrafund FCNTX suffered from asset bloat. However, Magellan got much larger, and its managers post-Peter Lynch were less able to adapt than Will Danoff has been at Contrafund. Contrafund was closed for a while, but Danoff has kept doing a remarkable job even as his total assets have grown above $ 100 billion. We pay attention to asset bloat even with the knowledge that the Danoffs and Joel Tillinghasts ( Fidelity Low- Priced Stock FLPSX ) of the world may be able to overcome it. Even they, though, would likely have had even better performance with smaller asset bases. Pulling Your Coat to Bloat So, how do you know if a fund is getting too big? As you can see, the picture is a little fuzzy. But I pulled together some data to let fund managers serve as your guide. I looked at the median asset bases at which funds closed at different market-cap levels.

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Why the difference? Maybe T. Rowe’s larger analyst staff gave it greater capacity. Maybe the existence of Franklin MicroCap beneath it put pressure on Franklin Balance Sheet to stand out from its sibling. Either way, the portfolio statistics and performance suggest that asset bloat was a bigger problem for Franklin Balance Sheet. The Problems of Asset Bloat Asset bloat can force a manager to alter his strategy. We’ve seen funds have tremendous success with small caps only to later forgo small caps because they weren’t practical. A manager dealing with asset bloat can also add more positions. That’s tricky, too, because the fund might not have enough analyst depth to fully research those new names. A bigger portfolio also means the fund now gets less out of its highest-conviction names and perpetually needs to pick more winners. Calamos Growth had problems when asset bloat outstripped its ability to research new names. A manager can also deal with asset bloat by trying to do exactly what he did before. The problem there is that trading costs will surge. If a 3% position amounts to $ 50 million of fund assets and the manager doesn’t move up in market cap, that means buying a much bigger piece of a company. In turn, that could lead to higher trading costs or greater market impact, mean- ing the fund drives up the stock price when it buys in greater volume and drives it down when it sells. Because liquidity is a key issue with trading costs, smaller, faster-trading strategies are more vulner- able than those with large caps and low turnover. Essentially, funds in the lower-right-hand corner of the Morningstar Style Box are most sensitive to bloat, and they get less sensitive as you move to the upper left.

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A less common, yet still irksome asset-bloat problem is hot money. When Fairholme FAIRX surged to $ 19