Fund Operations & Management

• Mutual Funds Become Less Diversified As They Get Bigger

Investment Management Compliance & Regulation

• Status Of Litigation By Mutual Fund Shareholders Against Fund Families

Investment Management Marketing

• Load Shares Overtaken By No-Loads And Threatened By SEC Reconsideration

Fund Operations & Management

• Stable Value Funds Ride Out The Downturn

• Mutual Fund Managers Seek Out The Old School Ties

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Trouble with lackluster performance. Mutual funds have grown both in number and in size over the last generation. Between 1975 and 2000, the number of US funds more than quintupled, and the mean asset value of individual funds shot up nearly ten-fold, while fund families tripled in number. Given this rapid growth in assets, size seems to be affecting fund managers' decisionmaking. According to research by finance professors Joshua Pollet and Mungo Wilson, actively managed mutual funds on average do not beat the markets, the indexes, or passive investment strategies. While a few funds turn in stellar performances and many outperform from time to time, hardly any do so consistently. Owning too much of one stock hurts liquidity, since the holding cannot be easily moved without affecting the price. Yet managers maintain their original investment strategies and holdings beyond the point where size makes doing so less efficient. A cynic might say the manager had just a few good ideas and was clinging to them, without any new notions (or perhaps enough staff to support a new concept) to attract fresh inflow.

Diversification enhances returns, but managers demur. Faced with snowballing assets, managers just keep plugging along, the authors find, buying more shares of what they already own. Although mutual funds do add new investments occasionally, they do so at an extraordinarily low rate. The numbers tell the tale. Comparing fund diversification by size quintile, the largest quintile at the start of the decade controlled over 86% of all mutual fund assets, averaged $6,189 million in assets under management, and held an average of 143.88 stocks. In comparison, the smallest quintile, with only 0.27% of all mutual fund assets, averaged $19.75 million under management and held, on average, just 73.01 stocks. The average top-quintile fund was over 300 times larger than the smallest-quintile fund, yet it held not quite twice as many stocks. The next-to-smallest quintile accounted for a little over 1% of mutual fund assets, averaged $84.64 million in assets, and held 90.31 stocks. The middle quintile had a bit over 3% of mutual fund assets, with an average of $231.72 million in assets and 97.26 stocks. The next-to-largest quintile, containing 9% of mutual fund assets, averaged $648.19 million under management and held 137.06 stocks. Although the largest quintile is nearly 10 times the size of the next-to-largest quintile, these megafunds hold only six additional stocks.

Memo from marketing: more funds, not more holdings. The study shows that diversification slows to a near halt as fund size increases, despite the fact that diversification is associated with better returns. (For small-cap funds, the diversity/returns correlation is even stronger.) Funds in large families diversify much more slowly than funds in small families, and their largest funds diversify barely at all. Increasing the size of the fund family—a decision driven by marketing concerns—also inhibits diversification within the individual funds at the larger fund families. These large complexes generally respond to burgeoning inflows, the authors find, by creating new funds to attract investors. This "product proliferation" strategy is easier for the fund family to market than a diversification of the familiar, existing funds.

Abstracted from Journal of Finance, published by American Finance Association, Haas School of Business, University of California, Berkeley CA 94729. To subscribe, call (800) 835-6770; or visit www.afajof.org/.