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Fund Spy: Morningstar Medalist Edition

When Funds Get Bloated

Too much of a good thing.

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A version of this article was published in the October 2015 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Has asset growth altered your fund's strategy? Has it done so to the point where it starts to hurt performance?

These are the questions that the bloat ratio aims to answer. The bloat ratio is a figure I came up with years ago to dig into issues of liquidity and trading costs. The raw ingredients for bloat ratio are the fund's turnover ratio, the fund's top 25 holdings and the number of shares it holds, and the average daily trading volume for those holdings. First, divide the average daily trading volume by the number of shares owned by the fund. That tells us how many days' trading volume the fund owns. The bigger the number, the less liquid the position. If a fund owns, say, 10 days' trading volume of a stock, it might take months to get out without crushing the price. Then, we take the average of the fund's trading volume figures and multiply by the turnover ratio. (That 10 days' trading volume position might be manageable for a fund with 10% turnover, but the trading costs will likely be steep for one with 100% turnover.) That gives us the bloat ratio.

It has merit both for descriptive and predictive power. It helps you understand the fund's bloat relative to peers. In addition, changes in the bloat ratio can signal changes in strategy, including those brought on by asset bloat.

In order to test predictive power, I grouped funds by their bloat ratio and then tracked returns over the ensuing five years. I looked within large-cap U.S. funds, mid-cap U.S. funds, and small-cap U.S. funds. I backed out expense ratios for the test in order to isolate bloat. One positive effect of asset growth is that expense ratios usually fall, so I wanted to keep that out of the equation. I also excluded funds under $100 million, as they are less likely to survive and less likely to be considered by many investors.

I looked at funds over a number of rolling five-year periods in order to capture a variety of market environments. I then looked at the average of those periods to understand what was going on.

Small Caps Are the Most Bloat-Sensitive
We grouped small-cap funds by decile, then looked at ensuing returns, success ratios, alphas, five-year Morningstar Ratings (or "star ratings"), and information ratios. Only the star rating is after expenses (as well as adjusted for risk and loads).

The pre-expense returns for the least-bloated decile were 11.51% annualized versus 10.04% for the most-bloated decile. The information ratio was 0.31% for the least-bloated decile versus 0.23% for the most-bloated. The least-bloated decile had a star rating of 3.04 versus 2.69 for the most-bloated. The success ratio for the smallest bloat decile was 43%, and for the bottom it was 35%. The success ratio tells you what percentage of the group survived and outperformed its peers. It is a way of preventing survivorship bias from creeping into the data.

For these measures, the bloat ratio would seem to have some useful predictive power, though I would not put it on par with the expense ratio.

It had less predictive power for alpha among small caps.

For mid-caps, the least-bloated decile slightly outperformed the most-bloated decile, but the impact was quite small. For large caps, no impact was apparent.

This makes sense as there is much less liquidity in small caps than in mid-caps and large caps. A fund would have to get enormous for bloat to be a big problem in large caps. More commonly, we see asset bloat become a modest handicap to which a manager may adjust by moving up in market cap and dialing down turnover. That can still be a negative, and you never want to see a manager alter his style to deal with asset bloat, but clearly the impact is generally small.

Biggest Increases in Bloat Ratio
Let's look at some of the large changes in bloat ratio, beginning with those where it went up.

By far the largest boost came at  Meridian Growth (MERDX), where bloat rose to 3.034 in March 2015 from 0.976 in December 2013, ranking in the top 5% of small-growth bloat ratios. The leap was due to the portfolio overhaul instituted by Arrowpoint's Chad Meade and Brian Schaub. The pair likes to run a focused portfolio, as this jump has made clear. The good news is that Meade and Schaub vow to close the fund well before it reaches the peak that their previous fund,  Janus Triton (JATTX), did. As the bloat ratio indicates, this is a strategy that is sensitive to size. In fact,  Janus Venture (JAVTX) had a 4.8 bloat ratio when they left, so they haven't yet come close to the extreme position they were in before.

 Longleaf Partners Small-Cap (LLSCX) is a different case. Its bloat ratio rose to 4.48, or top 2% of the category, from 2.95 despite the fact that it has been closed for many years and has even been in outflows. In this case, the rise was spurred by a rally in top holdings like  Graham Holdings (GHC), Level 3 Communications (LVLT), and Vail Resorts (MTN). Management allowed those positions to rise perhaps because it hasn't found much else to buy. At least this can't be pinned on asset growth.

 Aston/Fairpointe Mid Cap (CHTTX) saw a spike from 0.72 to 1.69 in June 2015. The fund closed to new investors in 2013, and the bloat ratio suggests that was a good idea. The fund continued to draw sizable inflows even after closing as existing investors kept contributing more money. However, the trend reversed in 2015, and the fund has had modest outflows as performance has been poor this year.

 T. Rowe Price New Horizons (PRNHX) saw its bloat ratio rise from 1.89 to 2.65 in March 2015. The fund did take in $1.2 billion in 2013 before it closed on the last day of the year. That pushed the fund's bloat ratio up under Henry Ellenbogen, but it might not be going higher now that the fund is in modest redemptions.

Even so, with $16 billion total assets under management, Ellenbogen has some real limits on the stocks he can buy and the speed with which he can trade them.

Biggest Decreases in Bloat Ratio
 Eventide Gilead (ETGLX) had a huge drop from 3.90 in 2013 to 0.06 in March 2015. The answer is turnover. It came down from 487% in 2011 to 91% in 2013 and 17% in 2014. Ironically, the cause may be asset growth. The fund was less than $100 million in 2011 and just $300 million in 2013 compared with $2.1 billion today. Although it now owns more days' trading volume in its stock, management really changed the way it invested by paring turnover in order to handle more money. Here, the bloat ratio is capturing a change brought on by asset growth, only it's because of a drop in the turnover ratio. 

Janus Venture and Janus Triton are the flip side of Meade and Schaub going to Arrowpoint. The funds' replacement, Jonathan Coleman, likes his portfolios more diffuse than they do. Thus, Janus Venture fell from 4.8 to 1.6. Coleman has about 40 more names in his portfolios than his predecessors did. Janus finally got around to closing Triton now that it has more than $7 billion in assets.

 American Century Small Cap Value (ASVIX) has come down sharply to 1.97 from 6.70, though it remains in the most-bloated decile of its peer group. The fund has seen about $800 million go out the door during the past two years; that's about one third of assets. The fund lost its lead manager in 2014, and it has been a middling performer in recent years. It is encouraging that outflows have cut the fund's bloat significantly. Those outflows might lead it to reopen in the coming months, but given the manager change I wouldn't rush in.

 Fairholme (FAIRX) is an interesting story among large caps. The fund's bloat ratio fell from 1.6 to 0.2, largely because of outflows. Yet, I wouldn't give the fund an all-clear on liquidity. While number-two holding  Bank of America (BAC) is a position equal to less than one day's trading volume and top holding  American International Group (AIG) is four days' trading volume, there are some huge positions in the rest of the top 10. The St. Joe Company (JOE) is 56 days' trading volume, and the fund's Fannie Mae and Freddie Mac positions wouldn't be easy to unload.

The Least-Bloated Funds
Most of the Morningstar 500 funds have above-average bloat ratios because they have above-average asset bases. But there are some diffuse small-cap funds that might be worth a look.  T. Rowe Price Diversified Small Cap Growth (PRDSX), with a Morningstar Analyst Rating of Silver, has a bloat ratio of just 0.05, placing it in the least-bloated quartile of small-growth funds. Vanguard Explorer Value (VEVFX) spreads assets among multiple advisors, and it is still pretty small. Its 0.05 bloat ratio is in the bottom third of the small-blend Morningstar Category.

Among mid-cap funds,  Harbor Mid Cap Value (HIMVX) has a bloat ratio of just 0.01, which places it in the least-bloated quartile of mid-value. Westport (WPFRX) has a bloat ratio of 0.01, which also places it in the least-bloated quartile.

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Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.