Mutual Funds and Mr. Creosote - Jason Zweig

Posted by jasonzweig on Dec 18, 2016

By Jason Zweig | Dec. 14, 2016 9:00 pm ET

Image credit: “Gula (Gluttony),” detail, Pieter van der Heyden after Pieter Bruegel the Elder, 1558, National Gallery of Art

For years, mutual-fund companies focused far too much of their energy on “asset-gathering,” trying to grow as large as possible as fast as possible. The needs of existing investors — decent performance at fair fees — were neglected in order to serve the managers’ own needs: chasing unsustainable performance to lure in new investors and maximize fees.

Many senior executives at fund companies are now warning that low-cost, solidly performing index funds are a kind of doomsday machine that will destroy the financial markets. But, even if that dubious assertion were true, the doomsday machine would still be largely of their own making. Had fund managers offered portfolios with respectable performance and reasonable fees, rather than cravenly seeking to cram swarms of new investors into hot funds that were predestined to grow cold, they would have stood a fighting chance against index funds. Instead, the typical fund company acted like Mr. Creosote in Monty Python’s The Meaning of Life, gorging shamelessly on bouts of new money from investors until it burst at the seams.

Here is an article I wrote more than two decades ago warning that many funds were dooming themselves with this sort of asset elephantiasis. How utterly sad that the future turned out to unfold almost exactly as I suggested it might. Amid all the crocodile tears being shed by fund managers over their recent difficulties, it might be worth a look back to see how they could have avoided the mess they’re in now.

Today’s Hottest Funds Are Too Big for Their Britches

Ballooning mutual funds are great for the folks who run them, but they may be a bust for you.

Money Magazine, April 1996

Last July 17, a Monday, a little-known mutual fund — AIM Aggressive Growth — blasted its way into the history books when it reopened to new investors after having been closed for just 14 months. The 11-year-old small-company fund, which had $990 million in assets, hoped to attract $150 million more. But by Tuesday afternoon, when it abruptly closed again, the fund had exceeded its wildest fantasies. In 48 hours, it had raked in $950 million — as much as America’s original mutual fund, Massachusetts Investors Trust, amassed in its first 31 years (from 1924 to 1955).

No doubt about it: The money flowing into funds has hit tsunami heights. Last year alone, $223 billion of net new money gushed into funds. Fully 29 funds took in more than $1 billion each. Fidelity, the king of direct-sales funds with $419 billion of assets now under management, had eight of these billion-dollar vacuum cleaners; the broker-sold AIM group, with $49 billion, had three.

All told, the nation’s 5,789 funds held $2.82 trillion by the end of 1995, up from $1.07 trillion in the 3,108 funds existing in 1990. That gave the average stock or bond fund $432 million in assets, compared with $248 million at the end of 1990.

And there’s no letup in sight. Stock funds alone took in a record $29 billion in January — more than twice the total they attracted in all of 1990.

Any way you slice it, the fund industry has grown very big, very fast — boosted in large part, to be honest, by 24-year-old MONEY, which has helped persuade a generation of Americans that they are better off investing in mutual funds than saving in banks.

Indeed they are. But at least one aspect of this stampede into funds is troubling. Put simply, when it comes to individual mutual funds, bigger is not always better. For investors like you, it’s often worse. When funds puff up, they can be transformed almost beyond recognition — meaning that new and existing shareholders may be relying on a very different fund than they think. And, as we’ll see, because sponsors get richer as funds get fatter, the fund industry has no incentive to correct the problem — and federal regulators aren’t equipped to resolve the issue, either.

To see how rapid asset growth can transform funds, I consulted the fund trackers at Morningstar in Chicago. We zeroed in on two groups of diversified U.S. stock funds. Each of the 102 funds in the first group had assets of $100 million or less at the end of 1990 as well as at the end of 1995; we’ll call them the ballerina funds. The 15 funds in the second group also started out with no more than $100 million, but each bulked up to $1 billion or more by the end of last year. We’ll call them the blimp funds.

How did the two groups of funds change from 1990 to 1995? Trust me: You’ll be amazed.

Adios, small stocks. The average market value of the stocks in the ballerina portfolios — the total worth of their outstanding shares — rose 58% (from $4 billion to $6.3 billion), well under the 92% hike in the S&P 500’s average stock value. But the size of the blimp funds’ typical stock shot up 209% (from $2 billion to $6.1 billion). The blimps started out owning far smaller stocks than the ballerinas but ended up owning stocks nearly as big.

Why might a fund be compelled to buy bigger stocks? Look at Twentieth Century Ultra. In 1990 it had $458 million spread across 62 stocks — an average of $7.4 million in each. Such small stakes can easily be bought or sold on the open market with little effect on the prices even of tiny stocks.

But by the end of 1995, Ultra had $14.6 billion in assets sunk in 134 stocks — $109 million per stock on average. If Ultra tried to buy or sell such huge blocks of small stocks, it could singlehandedly throw supply and demand out of whack — raising the price it pays to buy or depressing the price it gets on sales.

That’s called market impact, and it can wreck a fund’s performance. One way to skirt the problem is to buy bigger stocks — those with a greater outstanding share value. Today the market value of Ultra’s average stock is more than 10 times larger than in 1990 ($6.6 billion vs. $654 million).

Explains Ultra’s president, James Stowers III: “As hard as we try, there’s no way we can buy stocks as small as we used to. We have to buy bigger stocks to put all the money to work.” He adds with startling frankness: “Sometimes we wish we were smaller, because it’d be a lot easier job, and the returns might be higher too.” (Ultra’s 1995 return of 37.7% nipped the S&P 500’s 37.5% by a whisker.)

Or consider the Oakmark Fund. Launched in 1991, it had only $328 million at the end of 1992, and manager Robert Sanborn scored big on small stocks like Liberty Media. Sanborn had 10% of his assets and up to $45 million in Liberty while it rose thirteenfold from 1991 to 1993. But now Oakmark has assets of $3.6 billion. So there’s no way Sanborn can cram 10% of the fund — nearly $400 million — into one small stock, no matter how dazzling its prospects.

The result? “Embedded in the fund,” says Sanborn, “is a much higher percentage of the S&P 500 than there was two or three years ago.” Beating the market by loading up on small stocks like Liberty is a lot harder for big Oakmark than it was for little Oakmark.

The Ultra and Oakmark funds are hardly alone. Other funds where rapid asset growth has helped to drive up the size of the typical stock include Alliance Growth, Fidelity Advisor Growth Opportunities and Putnam Voyager.

Chock full o’stocks. From 1990 to 1995, the average number of stocks owned by the ballerina funds rose 55%, to 71; at the average blimp fund, the number of stocks rose 212%, to 176.

Why did the faster-growing funds buy so many more stocks? When a lot of money comes in, the manager is compelled to invest it; otherwise, he will depress his results in rising markets like that of the past five years. Most likely, he buys a growing number of stocks that are less familiar to him than his old favorites.

Look at PBHG Growth, which from 1990 to 1995 shot from $12 million in assets to $2 billion, a 17,000% gain. “I can’t honestly look you in the face and say the fund is no different from when it was at $50 million,” says manager Gary Pilgrim. “You need a wider span of attention when you own 130 stocks than when you owned 60.”

Common sense tells me the hottest fund managers are getting stretched thin. Even if they’ve added to their staff of analysts, how can they know all these new stocks as well as they did their old ones? And if these new stocks are such bargains, why didn’t the fund own little bites of them when it was smaller? Truth is, ballerina funds tend to own a few stocks their managers really love; blimp funds end up owning too many stocks the managers merely like.

Bygone bargains. In 1990, our group of ballerina funds owned stocks that were priced at an average of 15.9 times earnings; by 1995 their P/E ratios averaged 22.7 times, or 43% higher. But the blimp funds started out with a P/E of 17.7 and ended up at 26, or 47% higher. By comparison, the market’s P/E rose only 27% (from 16 to 20.4).

The obvious conclusion: The faster funds grow, the more they buy pricier, riskier stocks than they used to. Why? There simply aren’t enough good stocks on sale at any one time to absorb all the fresh cash. Check out Alliance Growth: In 1990 its typical stock was priced at 12.4 times earnings, or 23% below the market’s average P/E; at year-end 1995 it was 24.5 times, or 20% higher than the market’s level (based on the latest 12 months of earnings).

That brings us to the $3 trillion question: How have the blimp funds performed under these new burdens? So far, like sleek jetliners. From 1990 to 1995, reckons Morningstar, the blimps returned an annualized average of 25.7%, vs. just 13.3% for the ballerinas.

So why am I making such a fuss? This tidal wave of money is so new that it hasn’t yet had time to do much damage. But it will. There are already unmistakable signs of the troubles to come. Over the past decade, for example, a host of funds have slipped from market beaters to market laggards after pushing past $1 billion in assets. Among them: Evergreen Total Return, Janus Venture, Berger 100, Dreyfus Growth & Income and Vista Growth & Income.

Also, look to history. In 1968, the hot “go-go” funds sucked in billions of dollars almost overnight. Enterprise Fund, for example, took in some $600 million in 1968 — roughly equivalent to $2.6 billion now — thanks to its 118% return in 1967. But much of that new cash got sunk into the second-rate stocks then available. Result: In 1969 and 1970, Enterprise lost 45% of its value.

William Sams, 58, who now runs FPA Paramount Fund, joined Enterprise to help clean up the mess as a 31-year-old co-manager in 1969. What was it like? “Money was coming in at $6 million a day. There was even a machine with a readout showing how many callers couldn’t get through by the end of the day.” Sams laughs but then adds soberly: “The funds today have the same kind of cash inflows. I think we’ve got another speculative binge in the making now. It scares me to death.”

Me too. I trust I’ve made it abundantly clear that when your fund grows too big, too fast, sooner or later that’s bad news for you. Call it a truism. Yet fund companies keep pushing relentlessly to attract more money than they may know what to do with. Fund sponsors spent about $200 million last year on advertising alone, according to Competitrack, a New York City advertising research firm.

That insatiable craving for cash is proof that you and your fund manager have ultimately conflicting interests. You make the most money when the fund reaches its optimum asset size and sticks to it. But the fund manager makes money by collecting fees; the larger a fund gets, the more fees it pays the manager — regardless of how well it does for you.

Think of your fund manager as a real estate developer and your fund as a new house in the woods. Once you move in, you don’t want other people crowding in and spoiling your view. But it’s the rare developer who agrees with you. He wants to sell as many houses as he possibly can.

Harvard finance professor Andre Perold and money manager R.S. Salomon Jr. summed up this paradox in an article called “The Right Amount of Assets Under Management” in the Financial Analysts Journal five years ago. They explained that every money manager’s success carries the seeds of its own failure. The more unusual the manager’s approach was when he was small, the higher the odds that it will become unsustainable as his funds grow.

Therefore, concluded Perold and Salomon, “a firm’s first client should be unhappy to see other clients sign on. As new accounts are added, wealth created per client declines.”

Thus by encouraging floods of new money to pour into their portfolios, today’s mutual fund managers may be jeopardizing the future returns of their existing customers.

Consider the Kaufmann Fund, which ended 1995 with $3.2 billion in assets, up from a mere $39.5 million at the end of 1990. The fund’s typical stock is now three times bigger ($547 million vs. $164 million), and it owns eight times as many stocks (294 vs. 35). In 1995, after four straight years of walloping the stock market by as much as 49 percentage points a year, it slipped behind the S&P 500 slightly (36.9% vs. 37.5%), though so far this year it’s whipping the index (6.1% vs. 4.7%).

Is Kaufmann too big? “I don’t think it’s any harder [to run the fund] at this size,” co-manager Lawrence Auriana tells me. He says that recent computer advances allow him and his partner, Hans Utsch, to pick stocks as effectively as when the fund was small. Says Auriana: “The management is still the same. We’re good stock pickers.”

What’s more, he says, “We’re satisfied with our results.” And so are his shareholders. After all, a 28.6% average gain over five years is sensational.

Yet based on the analysis for this story, I believe Auriana and Utsch are endangering their returns, while enriching themselves, by continuing to solicit new shareholders with ads and direct mail financed by current shareholders. Like three out of every five stock funds, Kaufmann charges its shareholders an annual 12b-1 marketing fee (in this case, 0.6%) to pay for advertising, including space in Money, to lure more cash. On the assets they’ve attracted this way, Auriana and Utsch’s company will collect annual management fees of $51 million.

Auriana doesn’t agree with me. “The only people who are unhappy with the 12b-1 fee are the ones who didn’t invest in the fund,” he says flatly.

Now let’s turn to Fidelity Magellan. Last year, manager Jeff Vinik poured 43% of the then $54 billion fund — or $23.2 billion — into volatile technology stocks. Considering the risk Vinik took, his huge bet did not pay off very well: For the year, Magellan lagged the S&P 500 by three-fourths of a point — meaning that for the second straight year a plain-vanilla index fund beat mighty Magellan.

Is Magellan (now at $56.4 billion and counting) finally too big to sustain its great past returns? I think so. Should it close to new investors so it won’t become even more unwieldy? I say yes. When will that happen? No time soon, Roger Servison, Fidelity’s retail boss, tells me. “There is a [size] limit. When will we know what it is? We’ll know when we get there.” Which, unfortunately, may be too late for its current shareholders. Meanwhile, at today’s size, Magellan alone generates $423 million a year in management fees for privately owned Fidelity.

Fidelity has other gushers too. When the firm launched its New Millennium Fund in 1992, its marketing guide pledged that “the fund will limit its assets to $500 million.” This past November, the top-performing fund blew past $500 million — and kept on growing. Servison says the decision not to close was “based on the recommendation of the fund manager.”

When pressed about the written pledge in the marketing guide, he counters that it was not in “a legally binding document” and points out that New Millennium’s binding prospectus made no such promise. Lesson: When you deal with Fidelity (or any other fund company), read all the fine print.

In any case, that legal distinction will be cold comfort to existing shareholders if the rush of new money ends up hurting future returns — as I fear it will. Since it cleared the $500 million mark last fall, New Millennium has taken in roughly $100 million in new money, on which Fidelity will collect $1.2 million in management fees this year.

Fidelity is hardly alone in its eagerness to take in more money than clients expected. Last April, Gary Pilgrim closed his $1.1 billion PBHG Growth Fund to new investors “to maintain the highest level of performance for our shareholders.” The fund had grown from just $3 million at the end of 1992. Then, this past Jan. 2, the fund reopened.

Pilgrim explains that he’s added enough staff to handle the extra money, but he admits that his institutional small-cap account, which he closed at the same time, remains shuttered. “The pension consultants [for institutional investors] are more strict about these things,” he explains.

“We have yet to prove,” concedes Pilgrim, “that we can run a $3 billion fund as well as we ran a $3 million fund.” But, he adds, “everything we do is the same, except the stocks are a little bigger now. It’s encouraging that the past couple of years [of asset growth] have been among our best in terms of performance.” In January alone, PBHG Growth raked in $309 million — worth $2.6 million in annual fees for Pilgrim’s firm. Total assets now exceed $2.5 billion.

I asked Barry Barbash, the chief mutual funds regulator at the U.S. Securities and Exchange Commission, for his general thoughts about why more funds haven’t closed (or stayed closed) to protect existing shareholders. “One could be a cynic,” says Barbash, “and wonder whether fee income is the driving force. When your performance is good and people want to give you more money, it takes a very principled person to say, ‘No, I don’t want any more money.'”

There has always been a potential conflict of interest between the people who own the funds and the people who own the fund-management company. In fact, the first draft of the Investment Company Act of 1940, the law that governs mutual funds, barred any fund from taking in new money once it hit $150 million in assets — equivalent to $1.6 billion today, an amount that seems almost quaint now. The drafters of the bill feared that “too large an aggregation of capital could not be efficiently managed.” The final law omitted the $150 million limit, but it did empower the SEC to review “from time to time” whether funds are getting too big for their customers’ good.

The last time the SEC looked at the issue — 30 years ago — only nine funds had more than $1 billion in assets apiece. Still, the SEC warned in a report to Congress: “Should the growth of the largest funds and fund complexes continue, these funds might soon reach the point.where their portfolio mobility would be so seriously impaired as to affect gravely the interests of their shareholders.”

Today, 376 funds have more than $1 billion apiece. So I asked Barbash if the SEC plans a formal study of whether funds are growing too big, too fast. “We recognize that size is an issue,” he says. “But given our budgetary crunch at this point in time, I’d question whether we can do such a study.”

Translation: The marketplace is going to have to sort this out. And that means you. What are my suggestions?

First, think small. Don’t buy funds whose assets have skyrocketed — say, at least doubled or grown by $1 billion or more over the past year or so.
Second, stick with outfits that have shown they know when to stop taking in money — especially if you favor small-cap funds. Among them: Longleaf Partners, Quantitative Numeric, Royce, T. Rowe Price, Vanguard and Wasatch.
Third, lean toward funds whose managers put their own money in them. (This information is often found in the footnotes to the financial statements in fund annual reports.) As Longleaf’s Mason Hawkins tells me: “Our employees have more than $60 million of our own capital in the funds. We’re not driven by fees but by compounding our own capital. We did not want more money. Investing is difficult enough without having to do things that are irrational–like buying second-rate stocks just to put extra cash to work.”
Fourth, make large-stock index funds your portfolio’s cornerstone. They combat asset elephantiasis, since the managers must automatically invest in the same stocks — those represented in the benchmark the fund mimics — no matter how much money pours in. Or consider non-indexed large-cap funds, whose holdings are already big; new money will change them less radically than small-cap funds.
Fifth, take action. If you do own a fund that has grown very big, very fast, write the fund company, and the fund’s board of directors, and demand that no more new customers be brought into the fund against your best interests. If the directors are up for election on a proxy, vote to fire them.
Finally, keep your expectations in check. Many hot funds today can no longer maintain the nimble portfolios that made them famous. Your hot fund’s returns are likely to be more sluggish, and risk may well be higher, now that it has grown so large. If that bothers you (and your capital-gains tax bill won’t be too high), think about selling out of your hot fund and putting the proceeds into a fund that is not raking in assets as fast. You may have to give up a little performance in the short run, but in the long run I think you will come out ahead.