If your small-cap mutual fund has total assets on the hefty side, you might think of that as a red flag.
Let me explain by way of an example drawn from the archives of Roy Weitz's FundAlarm.com. Inspired by that website's 10th anniversary (it's just a little younger than the Fool!), I was poking through one of its early commentaries -- from November 1997 -- and ran across the following tidbit.
Weitz led off with this quotation, which he labeled as the "delusion of the month": "I think one reason we've been successful is that we focus solely on this fund. We don't want a whole family of funds that will divert our focus from this small growth area." That was uttered by Lawrence Auriana, co-manager of the Kaufmann Fund. I cringed when I read it because long ago, I myself had been a hopeful shareholder of the Kaufmann Fund. (And later, I was a disgruntled shareholder.)
Weitz then noted the following:
- Fact: Kaufmann is a small-cap fund with $6.3 billion in assets.
- Fact: As recently as 1995, Kaufmann had "only" $3.2 billion in assets.
- Fact: The average small-cap fund has about $289 million in assets.
- Fact: Only one small-cap fund is larger -- the 3-ALARM Small Cap World Fund.
- Fact: Kaufmann's 12-month performance has been dismal -- almost 21% below the benchmark.
- Fact: Kaufmann has trailed the small-cap benchmark since July 1995.
- Opinion: Kaufmann shows the classic signs of deteriorating performance caused by rapid growth in assets. Our suggestion: Watch it closely.
Weitz makes a lot of sense alluding to how it's almost inevitable that a fund with gobs of money will have trouble investing in very small companies. Since it can't put too much into any individual stock, it will end up spreading out its funds over many second- and third-tier ideas.
The fund struggled and ended up being acquired in 2000 by Federated Investors (NYSE:FII). When I looked up what happened to the fund after that, I found that it was renamed the Federated Kaufmann Fund (FUND:KAUAX), and in Morningstar's (NASDAQ:MORN) listings it is now labeled as a mid-cap growth fund, with top holdings that have recently included FedEx, Allergan, Cytyc, and Seagate Technology.
The fund has actually been performing decently in recent years, but its expense ratio is 1.95%, nearly twice the rate for the average mutual fund. Worse still are its loads. The A-class shares carry a front-end load of 5.5%, meaning that a $5,000 investment will get an immediate $275 haircut. The B-class shares carry a 5.5% back-end load and a 2.5% expense ratio. So if your $5,000 investment grows to $33,000 in 20 years, the load will bite off a $1,800 chunk when you sell. C-class shares carry a front-end load of just 1% and an expense ratio of 2.5%. That's a less painful load, but a fund should be performing outstandingly for you if it's going to levy a 2% or 2.5% fee every year. One lesson here is to consider all available classes of fund shares and to be very wary of steep fees.
As Shannon Zimmerman points out regularly in our Motley Fool Champion Funds newsletter, there are a bunch of top-notch funds that can serve you very well while charging reasonable, if not low, fees. (Take a painless free trial of the newsletter service, and you'll see his impressive long list of recommendations that are handily beating the market.)
Learn much more in these Zimmerman articles:
FedEx is a Motley Fool Stock Advisor recommendation.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
