Equity fund investors make stock purchases based on the belief that past returns are indicators of future performance, but whether size matters has been underestimated, especially for mutual fund investors, who belong to the so-called “loss averse” group.
Why are small equity funds not in favor?
- The effect of fund size on fund returns is most pronounced for those that play small company stocks, as liquidity is the key reason that why size erodes performance, and the organizational dis-economies related to liquidity. The relationship is not driven by heterogeneity in fund styles, fund size being correlated with other observable fund characteristics, or any type of survivorship bias.
- If the the mispricing that allows a manger to beat a benchmark occurs in the highly liquid large capitalization shares, the manager will likely continue to succeed, however, for a small-cap fund, the opportunity set may not be available to be exploited.
- Since small funds are less diversified, the poor performance of one stock will have a large negative impact on the overall portfolio.
- New and smaller funds can exhibit excellent short-term performance, but it can be misleading, simply because a few successful stocks in the portfolio could have a large impact on the fund’s performance.
- In addition, operating expenses tend to be higher for smaller funds due to the lower chance to take advantage of economies of scale.
What are the problems with large-cap equity funds?
- Large cap equity funds are difficult to manage in many situations. A large equity fund may find it hard to purchase smaller shares even when they have been confirmed undervalued, as a large fund manager cannot buy sufficient shares of a small company to add value to the fund at its current share price, although for a long-term investment strategy, it may be prudent to buy smaller cap shares precisely to capture value when the opportunity set represents.
- It is also difficult for large cap fund managers to move positions in the fund from time to time and are restricted in their stock picking options.
- Large cap funds are also more difficult to actively manage. As assets become larger, fund managers need to spread the assets over a large number of stocks because investing large amounts in one individual stock may affect the share price.
- As more and more investors are attracted to a fund, the manager face the need to put the cash to work as soon as they can, so they may purchase additional instruments that are not optimal for the investors.
Think about the best approach
- Consider the size of a fund in relation to the context of its investment approach and investment style. Funds tend to suffer when they outgrow their styles.
- Review and compare past cash holdings of the fund. A shrinking asset base means that the fund is losing money due to investors’ withdrawal or the performance of the portfolio has depreciated in value.
- Beyond that, compare the total cash holdings of the fund at current to those of previous time periods – a fund with large portfolio in cash may indicate that the manager is having trouble allocating the assets to various securities, and of course, exceptions exist in terms of this.
- Does Size Matter? An Analysis of Mutual Fund Transaction Size – David G. Shrider (Farmer School of Business, Miami University)
- The Role of Liquidity and Organization – Joseph Chen, Harrison Hong, Ming Huang, and Jeffrey D. Kubik