Five Funds Fighting the Battle of the Bulge
A closer look at asset bloat in the world's largest small-cap funds.
The May 2006 issue of Kiplinger's magazine contained an article called "When BIG Isn't Better," which concerned small-cap funds with large asset bases that remain open to new investments. The article warns against the evils of asset bloat--a sound warning--and suggests a good rule of thumb: A billion dollars in assets at a small-cap fund should serve as a red flag.
The article contains a table that ranks the 10 largest open small-cap funds by total assets. The table's organization could lead a reader to believe that the bigger a fund is, the more bloated it is. We don't think that's true.
Before examining the issue in depth, we should first define what asset bloat is. As a fund grows, it gradually becomes more difficult for management to execute its established strategy. Say a manager prefers to initially invest 1% of a fund's assets in each stock he buys. As a fund's asset base grows from $500 million to $1 billion to $3 billion, all things being equal, that gets tougher to do, especially in less-liquid small caps.
There are three primary "solutions" to the problem, all of which are signs of asset bloat. First, a manager can buy more stocks and make smaller bets on each of them. Second, she can own the same number of stocks in the same proportions, but buy stock in increasingly larger companies. Finally, the manager can move into and out of positions more gradually. This causes the fund's turnover ratio to drop.
So, while asset size is a clue as to whether a fund might be bloated or not, a more accurate way to identify whether a fund has gotten too big for its manager to execute its original strategy is to compare its current level of concentration, market-cap statistics, and turnover ratios to its historical ones.
While it's more art than science, understanding how a mutual fund's overall strategy has evolved is as important in assessing how well it will be able to carry its weight as is looking at current asset levels. With that in mind, I'll take a look at the five biggest open small-cap funds both to illustrate how to examine asset bloat and to assess each of them. We'll go in order, starting with the one we're most concerned about, and finish with the one we feel is in best shape. It should be clear, though, that we'd prefer it if all five were smaller than they are.
Franklin Small-Mid Cap Growth (FRSGX)
There's a big clue in this fund's history that signals its game plan for handling asset growth: In September 2001 the fund changed its name from Franklin Small Cap Growth to Franklin Small-Mid Cap Growth. According to Morningstar's statistics, the change was late. By the end of 2000, it devoted 48% of assets to mid-caps and only 31% to small caps. Looking at today's portfolio data, maybe Franklin Mid-Large Cap Growth would be a more appropriate moniker, as the fund devotes 13% of assets to large caps but less than 10% to small caps.
The fund also has other prominent signs of asset bloat. It is no longer as agile as it once was. The last time it held less than $1 billion in assets, in 1996, it had a turnover rate of 88%. Now it's 10 times that large, and turnover has fallen to half its old rate--43%. Plus, manager Edward Jamieson is spreading his bets more thinly: The number of holdings has expanded from 95 stocks to 137.
The most important ameliorating factor for this fund is that Jamieson has access to about 35 very solid analysts. In fact, Morningstar senior analyst Dan Culloton recently explained that the portfolio manager largely "serves as more of a maestro of the best mid- and small-cap ideas of the firm's analyst staff."
Of the five funds we're looking at, this is the only one to see performance suffer badly. From 1993 to 1996, the fund's returns placed in the top quartile of its small-growth peer group in its first four full years. Since then, it has cracked the top quartile of its category once--and has finished in the bottom half six times.
It's hard to give up on a once-strong fund, but if we owned this one we'd sell and move on to something more promising.
On the plus side, longtime manager John Rogers hasn't changed his very diligent, disciplined stock-selection process. He also hasn't decreased his conviction. The fund today holds about 40 stocks, demonstration that he is committed to a compact portfolio.
The fund has always featured low turnover, which remains true. Recently the turnover ratio was 19%; only twice in the last 10 years did it climb above 25%. In other words, the fund hasn't become less nimble--it never attempted to be nimble (as Ariel's choice of a tortoise as its mascot suggests).
Yet Rogers is shoving a lot more assets into those picks than he used to, and he's moved up the market-cap ladder to do so. The fund had only $205 million in assets in 1999, when the portfolio's median market cap was $846 million and 73% of assets were in small caps. The median market cap now is $2.75 billion--firmly in mid-cap territory--with only 14% of assets devoted to small caps. In remaining open, Ariel will likely have to keep climbing the market ladder in order to stick with Rogers' process, as a recent change to the fund's mandate acknowledges.
We'd be content to own this fund, but those seeking dedicated small-cap exposure should look elsewhere.
Columbia Acorn (LACAX)
Columbia Acorn is probably the most successful small-growth fund of all time, but at $18.5 billion, it's hard to see how it can continue to trounce its smaller, more nimble rivals as it has in the past. Yet there are reasons why we're not as worried about this fund as we are about the Ariel and Franklin funds. While it's not technically closed, it now has a $75,000 minimum investment for new shareowners. That's a very high bar, and portfolio manager Chuck McQuaid reports that inflows have slowed substantially.
The fund's unusual investment style is also a factor. The fund has always plied a low-turnover, growth-at-a-reasonable-price approach. Since the early 1980s, its turnover rate has been in the 20% to 35% range, although it has recently drifted down to between 10% and 20%. One driver of its low turnover has been founding manager Ralph Wanger's long-held belief in buying small caps but holding onto winners until their fundamental strengths wane. (Wanger recently retired.) It's never been a pure small-cap fund, though its 31.6% small-cap weighting has never been lower.
The fund's unusual structure is crucial to keeping us optimistic about its future. The world's largest open small-cap fund has a structure similar to the world's largest open mutual fund, the $137-billion American Funds Growth Fund of America (AGTHX). Wanger Asset Management now has about 30 research analysts who work with almost full autonomy here, and each need only come up with a handful of stock picks to feed this beast. Plus, as at Capital Research, the advisor the American funds, Wanger continues to add staff as a way to increase capacity.
To date, the fund's size hasn't harmed shareholders: The returns on its A shares land in the small-growth category's top decile over the trailing five-year period. We'd be surprised to see its success remain that lofty, but we wouldn't be surprised to see it continue to outperform. We'd hold onto this fund if we owned it.
Royce Total Return (RYTRX)
This fund is the most defensive vehicle on the list. It has a very specific mandate: to own only dividend-paying stocks. Small-cap dividend-payers are more rare than large-cap dividend-payers, so manager Chuck Royce believes the former's yields are largely ignored--and hence that there's a sort of systemic mispricing. He explains that the fund is designed to participate--but not fully--when small caps rise, and play stout defense (partially via dividends) in downdrafts.
We'd prefer to see the fund smaller than its current $6 billion size, but there are simple reasons why we're not particularly worried about the fund's prospects. First and foremost, it is meant to have a conservative, low-risk/low-reward profile, so losing agility isn't alarming. Plus, its dexterity appears stable. After having a 50% or so turnover ratio earlier in its life, it been very stable at about 25% for more than five years. The extra assets have caused its roster of stocks to expand; in early 2000 it held about 150 stocks, and now it holds more than 400. Plus its portfolio includes more mid-caps than it once did: In 2000 about 75% of assets were in small caps, but now it's less than half small caps.
We would continue to hold this fund and, depending on the role it plays in a portfolio, buy more shares. Investors should see the fund as a conservative way to own an even mix of small caps and mid-caps split fairly evenly between core stocks and value stocks. But if it's a dedicated small-cap fund in your portfolio, you should make sure that it's not causing your mid-cap weighting to be higher than you want it to be.
T. Rowe Price New Horizons (PRNHX)
T. Rowe Price, like Wanger Asset Management, employs a low-turnover, growth-at-a-reasonable-price approach that allows its funds to manage their girth better than aggressive, quick-trading funds. This fund has been heavy for a long time: It held about $4 billion a decade ago, and now holds just less than double that--$7.5 billion. A six-year period (1996-2002) when it was closed to new investors prevented its asset base from exploding.
Its fundamental statistics have changed, but more gradually than some others on this list. When manager Jack Laporte arrived in 1987, turnover ran at about 50%; it's now half that. And since 1999, its small-cap weighting has been fairly steady, moving between roughly 50% and its current 42% level. It's not spreading assets across more holdings, though: since 1999 it has held more than 250 stocks. More than any of the other funds here, this one looks much like it did a decade ago.
For that reason, we would continue to hold the fund and would be willing to add more shares if our asset mix was light on small-growth fare.
Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.