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Fund Spy

What's the Right Size for Your Fund?

What fund managers signal about capacity for a strategy.

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This article was originally published in the August 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

When should a fund close to new investors? How do you know when a fund has outgrown its capacity?

It's one of the trickier things to figure out from the outside. I've written in the past about the bloat ratio, in which I use turnover and the average daily trading volume of a fund's portfolio to understand which funds are being affected by asset bloat and which may have grown too large.

But you can also come at the problem from an altogether different angle. You can let portfolio managers tell you the appropriate size by looking at the records on fund closings. After all, they know their strategies well and have strong incentives not to close to new investors too soon as that would mean forgoing revenues.

Today, many small- and mid-cap managers have set a strategy's targeted assets under management from day one. They know what kind of market-cap expo­sure, turnover, and concentration they want to have in the fund, and that implies a certain level of capacity.

To be sure, there are still some "I know it when I see it" managers who simply aim to close when it becomes a problem. But once it's a problem, how does one dial it back to the optimal level? Also, the fund may well get additional money, as closing typically permits existing shareholders to make more contributions. In short, you have to get ahead of the problem.

Fund managers and fund companies that think long term have strong incentives to avoid a performance slump caused by asset bloat. To be sure, some fund managers and companies are much more inclined to go for the quick payoff and let a fund get too big.

In the short run, closing does reduce profits, but in the long run, doing everything to improve the chances for sustained outperformance pays off.

We have heard from a number of managers over the years who left their firms because they were not allowed to close a fund as quickly as they wanted or sometimes weren't allowed to close a fund at all. But those same managers make it plain just how important it is to manage capacity wisely.

Gathering the Data
To come up with a guide for asset size, I grouped funds by market-cap category and then pulled the median and average asset size at the time of closing. Because Morningstar does not store historical data on closings, I was limited to funds that are currently closed. I also weeded out funds that closed prior to liquidating because those cases don't have anything to do with managing asset growth. All passive funds were excluded, as such funds have very little capacity constraints other than their investment universes themselves. In addition, I excluded other special cases, such as funds designed solely for variable annuities or those with special legal structures that may have caused them to close for reasons other than asset size.

The data is most robust for small- and mid-cap funds as there are more closings and fewer funds in those groups overall.

Rule for Small-Cap Funds
For U.S. small-cap funds, the median closing point was $1.3 billion and the average closing level was $2.2 billion. Many of the funds at the low end of the closing level have a micro-cap focus or at least a significant level of those investments. Those at the high end have diffuse portfolios toward the upper bounds of small caps.

Thus, you can adjust your expectations up or down based on market cap, focus, and turnover.

Interestingly, the levels for foreign small/mid-cap funds are significantly lower. The median closing point was $756 million, and the average was $1.2 billion. Only one fund,  Oppenheimer International Small-Mid Company (OSMAX), closed at a level above $2 billion. U.S. small caps tend to be more liquid than those in many foreign markets, and the managers of these funds certainly are signaling that capacity is much more constrained in their realm.

Rule for Mid-Cap Funds
For U.S. mid-cap funds, the closing levels are about 2 to 3 times greater than for small caps. I found a median of $3.1 billion and an average of $5.6 billion closing asset level. That seems logical, as mid-caps are a significant step up in liquidity--particularly relative to micro-caps.

Rule for Large-Cap Funds
I put a little less stock in the large-cap figures because they represent a very small portion of large-cap funds out there. The U.S. large-cap funds that have closed are equally divided between those that are capacity-constrained because they are focused and those that grew very large before hitting capacity limits.

Thus, you have a  Longleaf Partners (LLPFX), which closed at $3.4 billion, and  Vanguard Primecap (VPMCX), which closed at $44 billion. I found a median closing level of $6.9 billion and an average of $12 billion. I would suggest using the median for focused funds and the average for wider-ranging funds from big fund companies.

Only nine foreign large-cap funds are closed to new investors, so take this with a grain of salt. The median closing asset level was $7.7 billion and the average was $15 billion. Those figures are not too far from what we saw for U.S. large caps.

Caveats
Naturally, creating these rules means missing out on some of the details of each case. For one, we're not factoring in turnover the way the bloat ratio does. I would expect a fund with turnover well above the median to need to close below the median closing level and vice versa.

The fund company itself is another missed variable. A smaller firm like Wasatch will likely need to close a fund sooner than one like T. Rowe Price, which has a much larger analyst staff and trading desk to move the equities.

I would also expect a firm using multiple managers operating independently to have greater capacity. For example, Vanguard closed its Primecap funds because it didn't want to dilute them by adding a second subadvisor, but many of its other funds have multiple subadvisors in order to expand the funds' capacity. Likewise, American Funds increases capacity by having each manager run a separate focused sleeve rather than having one manager run the whole show. That increases capacity, though probably not as much as the multiple subadvisor model.

Bigger fund companies don't get all the advantages, though. They are often more constrained because they have more than one fund investing in the same part of the Morningstar Style Box. Fidelity has quite a few large-growth funds run by different managers executing slightly different strategies. Those differences give the firm greater breadth, but inevitably managers will bump into each other when an analyst at Fidelity changes the forecast for a widely held stock.

Finally, we aren't considering separate accounts. They don't amount to much at some of the big firms, but others such as Artisan sometimes run more assets in a separate account than in the fund. These separate accounts are technically different vehicles, but generally they match their mutual fund counterparts very closely. Thus, you aren't seeing the whole asset base when you see fund asset levels.

 

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