At what point does
a fund’s size limit its performance? The major concern about giant funds is that their size and extensive holdings force them to mimic the overall market, something index or exchange–traded funds do at a fraction of the cost. As well, trading costs of mega funds are generally higher as their purchases of more and more of the same stocks boost bid/ask balances.

Several years ago, André Perold, a professor at Harvard Business School, showed that the bigger the fund, the more likely it was to take larger positions in the same set of stocks, driving prices up. More recently, a study by Boston University’s Vasiliki Plerou suggests this price impact is not always as significant as Perold first assumed.

More importantly, just last year, Joseph Chen of the University of Southern California concluded fund returns, both before and after fees and expenses, often decline with increased fund size. Does that mean investors should drop them in favour of cheap index clones?

Not necessarily, concludes a new study by James Bennett, a professor at University of Southern Maine in South Portland, and Richard Sias, a professor at Washington State University in Pullham. Just because a fund owns lots of stocks is no reason to assume its returns won’t differ from the overall market, they say.

This doesn’t mean such a fund will beat the market or necessarily shoulder less risk, the authors add. While portfolios spread across a large number of stocks are, on average, much less risky than smaller portfolios, a fund that holds many stocks can still deviate significantly from that average. And, although a broadly based fund does trim risk, they maintain it doesn’t eliminate it.

Rather than calculating how much risk is eliminated by adding stocks to an average portfolio, investors would be better off studying the chances that a portfolio will earn returns much different from those of the market, they say.

According to their findings, someone holding a 50-stock portfolio from 1966 through 2002 — which they use as a breakpoint between big and not-so-big funds — had a one-in-five chance of earning annual returns that differed from the market by at least 10%.
Doubling the amount of stocks to 100 stocks produced a one-in-five chance of earning differing results in the 7% range.

Costs aside, the possibility of veering this much from the market, generally referred to as the tracking error, determines whether investors can outperform the market. But few realize how much of this deviation they can expect from funds that own 50 or even 100 stocks.

Using the risk associated with the average fund as their guide, investors often overlook the fact that individual funds may differ significantly, the authors say. To them, the answer is not how much risk is eliminated by diversification but how much remains.

The common measure of diversification, which appears in the analyses published by fund-rating services such as Morningstar, is known as the “r-squared” — the degree to which a fund’s returns and those of the market simultaneously zig and zag. But a higher r-squared (the closer to 100, the closer the match) doesn’t mean a fund can’t lag by a huge amount, the authors say. To them, this suggests most actively managed funds are not as diversified as investors may think, and they are incurring more risk than they realize.

It comes down to the ongoing passive/active argument. If you believe a top-level manager can beat the market, you should be comfortable with big funds that hold large numbers of stocks, even though they hold some tracking-error risk.

For risk-averse investors, the nod goes to index funds or equivalent ETFs, as there seems no other way to eliminate risk of underperforming the market by a large margin. IE