Imagine that you're the manager of a mutual fund with $10 billion in assets under management. If you want to invest just 1% of your portfolio in a stock, you have to make a $100 million purchase. To the detriment of your investors -- and your returns -- your investment choices are clearly limited.
The stocks you can't buy
See, historically speaking, small-cap value stocks are among the market's best performers. But to make a $100 million investment in a small company (capitalized at less than $1 billion), you'd have to take a 10% (or greater) stake. That would compel you to file with the SEC, and to report any changes in your ownership to the SEC within two business days, thus allowing your competitors to see exactly what you're doing.
What's more, a 10% ownership stake would make you very influential, and perhaps even get you a seat on the board. That would be great for a corporate raider trying to usurp current management, but it could give a passive fund manager an operational headache.
And if that's not bad enough, small-cap stocks typically have lower trading volume than larger stocks do, and a $100 million investment would skew buy-side demand -- resulting in a much higher price paid per share by the time the order was completely filled.
Great. Now what?
Essentially, as the fund manager in this situation, you're left with two options:
- Spread the $100 million across hundreds of small caps. Or …
- Buy larger stocks.
Successful small-cap fund managers frequently run into this problem when cash begins pouring in to their funds from investors chasing past returns. Even Warren Buffett has lamented his $44 billion cash hoard -- he notes that he could earn 50% per year if he had just $1 million to invest.
As a result …
This may be part of the reason that small-cap funds with billions in assets under management -- such as Neuberger Berman Genesis (NBGNX) -- tend to be closed to new money and have hundreds, if not thousands, of stocks in their portfolios. Many also contain solidly mid-cap names among their top holdings.
For example, the Neuberger Bergman fund holds names such as Denbury Resources
For the same reason, mutual funds with assets under management of $100 billion or more tend to focus on large caps even as they call themselves "multicap" investment vehicles. American Funds Growth Fund of America's (AGTHX) average holding, for example, has a market cap of more than $47 billion, and its top holdings include giants Cisco Systems
A 2002 study titled "Does Fund Size Erode Performance?" explored this conundrum to a greater extent. As authors Harrison Hong, Ming Huang, and Jeffrey D. Kubik note: "The effect of fund size on performance is most pronounced for funds that play small cap stocks. This suggests that liquidity is an important reason behind why size erodes performance."
That's a problem for investors seeking to diversify with true-blue small caps. Larger small-cap funds fail to properly diversify your portfolio, because they cannot invest significant sums in illiquid, small companies. As a result, you, the investor, end up missing out on the benefits of small-cap stocks.
There's your opportunity
If you're looking for true small-cap exposure from your mutual funds, begin by hunting for leaner funds (less than $1 billion in assets) that can make meaningful investments in great small stocks with huge potential.
If you're in the market for such funds -- or any mutual fund, for that matter -- the Motley Fool Champion Funds team can help you find the best of the best. Led by advisor Amanda Kish, the Champion Funds team looks for funds with:
- Low expenses.
- Low turnover.
- Tenured managers who have their own money invested in the fund and possess a proven track record.
To date, that tack has worked -- the service's picks have returned nearly 25% on average, compared with 9% for the S&P 500.
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Fool contributor Todd Wenning misses the stale gum they used to put in packs of baseball cards. He does not own shares of any company mentioned. Time Warner is a Motley Fool Stock Advisor choice. The Fool's disclosure policy has a glossy finish.