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Rekenthaler Report

When Are Stock Funds Too Big?

Morningstar’s new paper advances the analysis.

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Fool's Gold
There was a time when I sought the Northwest Passage. How to turn lead into gold. Capturing Yeti. Ah, the dreams of youth.

After many years of failures, I conceded. Try as I might, there was no way to calculate a stock fund’s trading costs from its asset size, turnover, and portfolio holdings. The error term dwarfed the estimate. The best that the measurement could do was to suggest that large funds that rapidly traded small companies incurred relatively high trading costs. Well, great. We knew that already.

The problem with trying to determine trading costs from the outside is that the critical information rests inside. After each quarter, we know exactly how many shares of each stock were bought and sold. But we don’t know the urgency of those transactions – whether the trades were pushed through quickly, or very patiently, waiting for the market to come. We also can’t gauge, as can a fund’s trader, the extent to which the fund’s actions drove the stock’s price.

Therefore, fund companies can judge with accuracy when their offerings have become too big for their britches--when a fund’s bulk forces it either to change its investment approach or to pay heavily for when it trades. Morningstar (or any other outside party) cannot. Its process, one might say, requires some artistry.

Stepping Back
 “Evaluating Capacity and Liquidity for Equity Strategy,” a new white paper from Morningstar’s Tom Whitelaw, outlines the process. As, despite my efforts, researchers cannot rely on a single calculation to give them the answer. Instead, they consider several signals, attempting to assess when changes within funds merely indicate caution, as opposed to the crossing of a line.

Complicating matters is that investment firms don’t just run mutual funds. They may manage institutional funds, separate accounts, or collective investment trusts, to name three possibilities. The mutual fund can easily be seen; the other investments cannot. They lie underneath the water. To assess whether a strategy has exceeded its capacity, the researcher must locate and account for its ancillary assets. (Another problem for my unicorn hunt.)

Possible Indicators
Among the attributes to be considered are:

1) Net Inflows

Of course.

2) Speed of Inflows

This item is less obvious. That an ostensibly small-company fund grows from $500 million to $5 billion is a yellow light. That the increase occurred in less than two years, as with  Virtus KAR Small-Cap Growth (PSGAX) (the paper’s main example), turns the signal red.

In such situations, management must let cash accumulate; incur steep trading costs; or modify its investment approach, either by expanding its number of holdings or by purchasing the shares of larger companies. In all cases, the fund becomes something other than what it was.

3) Company Size

Assessing whether a fund has moved up the market-capitalization scale by buying into larger firms isn’t quite as straightforward as it sounds. Eyeballing the portfolio is, of course, insufficient. The task requires more precision than that.

But the traditional calculations have their flaws, too. Computing a median ignores all information that falls above or below the middle. If the fund swaps its relatively large-cap holdings for true giants--say,  FactSet (FDS) for  Apple (AAPL)--the median will be none the wiser. Similarly, one can also game simple averages.

Thus, researchers are best served by viewing several measures. The fund’s median and average stock market capitalizations are good starts. In addition, Morningstar computes something called a Size Score, which slices the data in its own fashion. If the portfolio has changed its character, at least one of those indicators will flash.

4) Number of Holdings

Enough said.

5) Portfolio Turnover

At some point, investment managers reduce their trading, rather than chase stocks while purchasing them, and depress their prices while selling. They can see the damage caused to their portfolios by market disruptions.

Perhaps, as active management’s critics would have it, this decreased activity is a good thing. It may prevent portfolio managers from making mistakes. That could be so. However, the reason to consider capacity issues is not necessarily to arrive at a sell decision but to understand what one owns. Whether shareholders accept the lower turnover rate or reject it as a change in the fund’s fundamental character is up to them.

6) Cash Weighting

This item is also obvious. And it also can be beneficial. Any fund that was flooded with new assets this summer and that entered October with a larger-than-usual cash position is now the wealthier for that condition.

Such an event would not please me. If I possess a stock fund that normally is fully invested, I would wish for it to remain that way. But again, such decisions are personal. The important thing is to know what one owns, so as not to be disappointed when stocks recover and that fund lags.

Looking Forward
The above information is readily available for those who use the free version of and who wish to do their own analysis. For those who prefer to piggyback on others’ work (as, yes, I have done with this column), Morningstar’s manager research analysts are charged with alerting their readers should they see potential problems with a stock fund’s capacity.

For me, that is a good answer, but not great. While I acknowledge that my previous quest was futile, it still seems to me that Morningstar could devise some single measure of capacity that could be used as a screen, so that mutual fund investors wouldn’t need to hunt and peck, fund by fund, to arrive at the answers. This measure wouldn’t be precise, as with my attempt at calculating trading costs. Rather, it would be a general indicator, showing if there should be a high level of concern, a medium level, or no concern at all.

Happily, that is indeed the plan. Tom and team have devised several new calculations, which they hope will eventually become the basis, when combined, for such a general indicator. These calculations (measures of liquidity, such as 1) the number of days required to liquidate the portfolio, or 2) changes in historic liquidity) have not yet been released. It is early days yet. It does appear, though, that Tom’s group will accomplish what I did not. That is a good thing. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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