It's rarely a good thing when a mutual fund gets really big -- size can hurt its performance. Does this sound counterintuitive? Imagine you're suddenly given $30 billion; you'd probably be pleased. But if the money were given to you as a stock mutual fund that you had to manage, you'd run into some problems. Mutual funds have strict rules that make effective investing difficult.
For starters, you'd likely have to keep 5% to 10% of the fund's value in cash, to cover withdrawals when people sell shares. You also probably wouldn't be able to invest more than 5% of the fund's value in any one stock, limiting you to no fewer than 20 stocks. Typically, mutual funds invest in 50 to 200 different companies, a far cry from the six to 15 stocks that Fools with the time and willingness to invest in individual stocks should shoot for.
To better appreciate the problem of overdiversification, take a look at Fidelity's mammoth Magellan Fund. As of the end of 2006, one of its biggest holdings was Nokia, representing 3.5% of the fund's value. If an investor had plunked $3,000 into Magellan then, she'd own only $105 worth of Nokia -- in other words, between five and six shares' worth. And that's the biggest holding. Of her $3,000, $159 would be divided among nine pharmaceuticals companies, such as Johnson & Johnson (NYSE:JNJ) and Merck (NYSE:MRK), for an average of $17.67 each. Some $84 would be divided between seven "computers and peripherals" companies, such as Apple (NASDAQ:AAPL), Seagate, and Hewlett Packard (NYSE:HPQ) -- amounting to an average of $12 each.
Being spread so thin is problematic, because when you're invested in hundreds of companies, the impact of the ones that do very well is diluted by many less stellar performances. If Boeing (NYSE:BA) triples in value one year, for example, your stake in it might simply go from $6 to $18, even though you may have $3,000 invested in Magellan. If an individual investor had invested $3,000 in 10 companies in equal proportions, and one had been Boeing, the Boeing stake of $300 would have turned into $900, increasing the portfolio value by 20%. The more companies you own, the more dilution becomes a problem.
Even if your fund limits itself to owning the minimum number of stocks, other problems can arise. Let's return to your imaginary $30 billion fund. Imagine that you want to (and can) spend 10% of its value, $3 billion, on Callaway Golf. Oops. Callaway's entire market value (at the time of this writing) is around $1 billion. Even all of Barnes & Noble (NYSE:BKS) is only $2.6 billion.
If you're limited, as many managers are, to not buying more than 10% of any one company, then you could spend only $200 million on a $2 billion company. It's hard to avoid spreading yourself too thin when $200 million is merely a drop in your mutual fund's bucket.
Pity the mutual fund managers. Working with much less freedom and a lot more money than we have, the odds are stacked against them. It's no surprise that many of them underperform the market average.
You can take much of the headache out of investing and meet the market average by investing in index funds, which everyone from Fool co-founders David and Tom Gardner to John Bogle to Warren Buffett recommend.
Let us help you be a better mutual fund investor. You could do a lot of research online, searching for funds with long, strong track records and managers who inspire your confidence and trust. Or you might simply grab a free trial of our Motley Fool Champion Funds newsletter, and see which funds our analyst Shannon Zimmerman is recommending and has recommended.
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Johnson & Johnson is a Motley Fool Income Investor recommendation, while Merck is a former recommendation of the newsletter.
Longtime Fool contributor Selena Maranjian owns shares of Magellan and Johnson & Johnson. The Fool has a disclosure policy.
