Financial advisers study hundreds of investment options and get bombarded by marketing pitches for hundreds more. So it's rare that a skeptical veteran likes a mutual fund so much that he recommends a single fund to almost all of his clients for years. Yet, for almost two decades, Benjamin Tobias had just such an admiring relationship with one particular fund: the Growth Fund of America (AGTHX). Tobias first eyeballed the high-flying fund in 1987, when he was starting his Florida practice, and he liked what he saw. The fund consistently beat the market, and the fund's management company, Capital Research and Management, kept its fees low. Throughout the 1980s and '90s, with
Tobias's clients on board, its returns routinely crushed the broad Standard & Poor's 500-stock index.
Over the years, plenty of other investors noticed the Growth Fund of America's success too. In a single five-year stretch, the fund quadrupled in size, and by 2006 it had more than $160 billion in it, making it the largest mutual fund the country had ever seen.
But while the fund's sheer size had turned it into the toast of the industry, Tobias began to notice a disturbing trend about the fund: The bigger and bigger it got, the weaker and weaker it performed. While the Growth Fund of America did make money for its shareholders, it wasn't actually performing any better than an S&P 500 index fund. By 2006 it was doing even worse. Tobias was puzzled, and says he tried but couldn't get answers about the management of the fund's sprawling portfolio. (A fund spokesperson says it doesn't disclose which people manage specific parts of the fund.) Ultimately, in 2007, Tobias did what would have been unthinkable just a few years earlier -- he sold the fund's shares en masse. In his mind, the fund is just too big -- and so are many others. "I've lost the ability to distinguish them from index funds," he says.
These funds ballooned in size after years of stellar returns. But it's been a different story more recently.
The mutual fund industry has its own big gulf between the 1 percent and the 99 percent. Americans can choose from more than 7,600 mutual funds, but much of their cash winds up in an elite few. Indeed, the country's 100 biggest funds hold almost $3.5 trillion. To put it another way, 30 percent of all the money in the U.S. fund world is invested in about 1 percent of the funds. These megafunds have fattened up on a combination of money flowing from employer-based retirement plans, college savings accounts and investors picking funds based on their well-established brand names. The average size of a top-100 fund has increased by 62 percent since 2008, to $35 billion. Today the nation's No. 1 fund is the bond-centric Pimco Total Return (PTTAX); at $244 billion, it's larger than the annual gross domestic product of Finland. The Growth Fund of America is now the No. 3 fund; it could, with its assets, buy all the shares of tech giant Cisco. And these megafunds give the firms that run them reason to celebrate: They can generate hundreds of millions of dollars in fees annually for their companies.
Put a Lid on Them
These pros say their funds have succeeded, in part, by turning some money away.
One reason the funds have grown so large, of course, is that they historically delivered great returns to their investors. But more recently, that story has begun to change -- and there's growing evidence that bigger is no longer always better. According to a SmartMoney analysis, the average megafund was no better than about 40 percent of its peers over the past year, or over the past three years. That mediocre average masks some even more stunning numbers for individual funds. Pimco Total Return, for instance, ranked in the bottom 15 percent of its peer group last year. And one giant fund has lagged behind 97 percent of its rivals -- over the past five years. It's making some market experts wonder whether big mutual funds offer more advantages to fund companies than they do to investors. "There are no benefits to a fund being bigger. Success breeds sloppiness," says Seth Lipner, a securities lawyer and a law professor at the Zicklin School of Business at Baruch College.
The firms that run the megafunds bristle at the idea that their size is hurting their returns. Fund managers who have lagged attribute some of their woes to the ebbs and flows of the market. Certainly, some supersize funds have continued to excel, and even those that haven't are usually charging below-average fees. But critics say that while investors are paying less, they're also getting less. The sheer size of the funds, some industry observers say, has become a roadblock that even forces some managers to act against the best interest of investors. In the eyes of these critics, America's megafunds could be too big to succeed.
The nation's largest actively managed stock mutual fund is run out of a skyscraper in downtown Los Angeles, a few blocks away from the city's famed Museum of Contemporary Art. The Capital Group, which operates the Growth Fund of America along with the fund's distribution arm, American Funds, has been around for more than eight decades. According to company lore, a Detroit banker named Jonathan Bell Lovelace realized that stocks were overvalued in the late 1920s, so he took most of his personal investments out of the stock market before the great crash of 1929. Lovelace moved out to California and founded an investment firm in 1931. The firm successfully managed money for decades and then, in 1973, launched the Growth Fund of America.
Get What You Pay For?
The pay some large fund managers take home, versus their funds' performance.
|Fund||Management Fees (millions)*||Rival Funds That Did Better (Past 3 Years)|
|Pimco Total Return||$598.8||52%|
|Growth Fund of America||427.0||77|
* Fees paid to management team in most recently reported fiscal year.
Source: Mutual fund filings
Unlike many funds at the time, or even now, the Growth Fund of America was set up to be managed by multiple layers of investment pros. There are 12 "portfolio counselors," each responsible for managing a slice of the fund. Those counselors are supported by about 50 stock analysts, who are scattered around the world, scouring sectors and investigating individual companies for potential investments. (That's a big team; some nationwide brokers with millions of clients have fewer stock analysts.) The fund staff has multiple teleconferences each week, during which they discuss daily market moves and potential changes in the fund's dozens of holdings. "We are not trying to figure out the next quarter or two," says Terry Ragsdale, a vice president at the Capital Group. "We are trying to figure out where companies we invest in will be in five years and what we should pay for them."
For the better part of 30 years, the fund could do almost no wrong. Sure, the '80s and '90s were pretty good times for most stock investors -- a $10,000 investment in the broad stock market in 1973 would have been worth about $400,000 by 2006, an average gain of 12 percent a year. But the Growth Fund of America shattered that benchmark: $10,000 put into the fund in 1973 was worth more than $1 million by 2006, an average return of more than 15 percent a year.
Performance figures like these get noticed by a lot of people -- individual investors, naturally, but also financial planners, pension fund managers and the consultants who put 401(k) plans together, says Geoffrey Bobroff, himself a fund industry consultant in East Greenwich, R.I. Thanks to the years of success, the Growth Fund of America became a 401(k) darling. From 2001 to 2006, the fund got nearly $80 billion from investors, according to Morningstar, with much of that cash coming from retirement plans. The halo from the Growth Fund also helped the Capital Group successfully launch additional funds that focus on small stocks, bonds and other investments. These days, the Capital Group runs 16 of the nation's 100 biggest funds, with nearly $800 billion in combined assets.
The fabulous past performances have helped attract money to numerous other firms as well. Over the past three years, there's no better example of a fund getting supersized than Pimco Total Return, the bond-focused fund run by iconoclastic manager Bill Gross. In 2008 the fund already had $132 billion in it. But thanks to Gross's successful navigation of the bond markets during the worldwide financial crisis, the fund delivered returns almost unheard of in the stodgy bond fund world, up 8 percent annually, on average. Investors beat a path to Pimco's door: In three years, the fund has gotten almost $70 billion in new money from investors. With resources like that, a fund firm can lower the expenses for each individual investor. (The annual fees on Pimco Total Return are $90 for each $10,000 invested -- cheaper than the industry's average.) A fund's success can also make a star out of a fund manager -- which, in turn, helps the fund raise more cash. Pimco's Gross is an almost daily presence on television; his hobbies (yoga and stamp collecting) are nearly as well known to investors as his ability to pick bonds.
Indeed, many megafunds wind up a reflection of the people who run them. Before he ran the nation's 42nd-largest mutual fund, Christopher Davis studied theology and philosophy at the University of St. Andrews in Scotland. Davis says he considered both the priesthood and a career with the CIA before he entered what essentially was a family business: His father, Shelby, was a legendary investor who had run the fund since 1969. The younger Davis became comanager of the Davis New York Venture portfolio (NYVTX) in 1995 and continued its impressive performance. From 2001 to 2006, thanks to savvy investments in names such as Costco and Berkshire Hathaway, the amount of money in the fund doubled. If the fund does make a mistake, Davis makes sure it's not forgotten: He hangs the stock certificate on a wall in the office, along with an explanation of why the investment failed.
But time and time again, the gaudy performance figures that have made megafund managers so proud disappear as the funds get bigger. Columbia Acorn (ACRNX), a $16 billion fund, has made a fortune betting on small and midsize stocks since the 1970s. A $10,000 investment at the end of 2008 would be worth about $16,000 now after deducting fees. That's a good return, for sure. However, it trailed the average rival fund and even the index tracking midsize stocks. (The fund's lead portfolio manager, Chuck McQuaid, says Acorn has been hurt of late by some rocky foreign investments, but that its 10- and 15-year records remain very strong.) Over the past five years, nearly three out of four rival funds have outpaced the Growth Fund of America.
Fidelity Magellan (FMAGX), which had been the nation's largest mutual fund for years, closed to new investors in September 1997. Fidelity believed that the fund, which at the time had almost $63 billion, was getting too big. The firm might have been right: An investor who put $10,000 in the fund right before the fund closed would have about $14,000 now, while an investment in the S&P 500 would have yielded nearly 30 percent more."There is an element of mediocrity that enters the picture when the fund gets too big," says Doug Kinsey, a partner at Artifex Financial Group in Oakwood, Ohio, who's managed money for 15 years.
Davis New York Venture has experienced similar mediocrity. A $10,000 investment in the fund in late 2006, when it had $44 billion in assets, would be worth about $8,900 now (the same investment in the S&P 500 would be worth about $9,900). Over that stretch, nearly 80 percent of rival funds outperformed Davis. The manager is more than willing to rehash his mistakes. In an interview, Davis says he misjudged what a financial crisis could do to two of his biggest holdings, Merrill Lynch and AIG. Perhaps even worse, he didn't buy more of his favorite stocks, American Express and Wells Fargo, when their share prices were depressed in early 2009. But he also says that his fund's size, even at its now-shrunken $21 billion, makes it trickier to play the market. When you're a big fund, Davis says, "it's harder to be nimble."
Indeed, some managers turn money away expressly because they fear their funds will get too big. The $1.4 billion Brown Capital Management Small Company fund (BCSIX) has beaten 99 percent of all of its small-cap fund competitors over the past five years. Yet last October, the fund shut its doors to new investors. Keith Lee, the fund's comanager, says a lot more money could have forced the fund to make bad investments. "We thought it would be wise for our investors to close the fund to preserve the investing process," Lee says.
Asset managers can point to plenty of big funds that have done just fine in recent years. Fidelity Growth Company (FDGRX), Harbor International (HIINX) and Vanguard Wellesley Income each have at least $25 billion in assets; all three have beaten 90 percent of their respective rivals since 2006. But other industry experts agree with Davis: Being a giant fund brings along its own set of giant problems. When millions of new dollars are flowing in each week, portfolio managers sometimes have to scramble to put the money to work -- and there are only so many good investing ideas out there. One of the toughest situations, fund managers say, is when money gushes in because the category the fund resides in has been doing exceptionally well. There's little doubt that the amount of money Pimco Total Return has attracted has been helped by the fact that bonds have been a great investment since the financial crisis, luring nearly $700 billion in new assets to bond funds since the beginning of 2009. Once the prices of such investments have been driven up, says fund company consultant Bobroff, it's "difficult to deploy the new money in a way that doesn't hurt existing shareholders."
Even successful megafund managers have had to change their investment tactics, industry analysts say. Fidelity Contrafund (FCNTX) has managed to outperform its rivals even as its assets ballooned from $300 million two decades ago to nearly $73 billion now. But the fund's manager, Will Danoff, trades a lot less frequently and puts a much heavier emphasis on large stocks than he did when he first started running the fund. The fund's girth also limits Danoff's ability to build up a large position in any firm that isn't itself supersize, experts say. For instance, the fund holds more than two dozen gold mines; one of its biggest stakes is in Franco-Nevada, a midsize Canadian company -- but Franco-Nevada makes up only 0.6 percent of Contrafund. By contrast, 8.2 percent is devoted to its top holding, Apple. If Danoff wanted to commit 8.2 percent of Contrafund to Franco-Nevada, he would have to buy $5.9 billion worth of the miner's stock. There's one problem: The total value of Franco-Nevada's stock is only $5.8 billion. Danoff might have to invest in a few pickaxes, because Contrafund would, literally, own the entire gold miner. Danoff says he still invests in smaller firms, but the fund's rules preclude him from owning more than 10 percent of any company's stock; so he can't buy much of a small firm, even if he wants to. "The arithmetic is pretty obvious," he says.
But perhaps the most intriguing problem megafunds face, some critics say, is that as they grow, the link between their revenue and their performance can become more tenuous -- leaving them with less incentive to excel for their shareholders. More than 70 percent of rival funds beat the 2011 performance of the Growth Fund of America. The fund still brought in $427 million in annual management fees to the Capital Group. Generous as that payday sounds, it represents only about 0.3 percent of the fund's total assets -- which means the fund would have to put up some awfully good performance numbers before the management company would see much of a bump in its profits. For Capital to raise the amount of income it earns off the fund by just 10 percent, the fund's assets would have to increase by more than $34 billion. That's greater than the assets of all but 30 of the nation's more than 7,600 funds.
The Capital Group's Ragsdale says compensation for the Growth Fund's managers and analysts isn't based on how much money they manage and that they can earn bonuses when they beat the markets. Still, even off years are lucrative for the biggest funds: Together, the 10 biggest megafunds earned nearly $3 billion in fees for their respective fund companies in their most recent fiscal years, according to their regulatory filings. "Running a good mutual fund marketing campaign can bring in a lot more money, and be a lot less risky, than trying to outperform," says Jeff Tjornehoj, a senior mutual fund strategist at Lipper.
The managers of megafunds say their critics are ignoring the long view and focusing on short-term failings. If a megafund has done poorly recently, the firms say, it's because the market has turned against them or because their managers made some poor investment decisions -- not simply because the fund is big. The Growth Fund of America's performance is similar to the S&P 500 index's over the past five years, but Ragsdale notes that the fund did better during the previous five years. "Since 2008, it has been a very unusual market, making it more difficult to add value as a stock picker," he says. Some big funds that had recent setbacks don't concede that they've made mistakes, either. With an excellent five-year record, the $60 billion Templeton Global Bond fund (TPINX) had a terrible 2011: It was beaten by 96 percent of other international bond funds. The fund's manager, Michael Hasenstab, says if he could go back and do 2011 over again, he would make exactly the same bets.
Hasenstab's confidence aside, some firms are willing to make some adjustments to the megafund model. Fidelity Magellan, formerly a $110 billion fund, has shrunk to about $15 billion after a decade of bad performance. Last September the firm brought in one of its veteran managers, Jeff Feingold, to help revive the fund. Whether Feingold can turn things around at Magellan remains to be seen; he's the fund's third leader since its assets peaked in 2000, the fifth since Peter Lynch left the helm in 1990. Feingold says he expects Magellan, under his leadership, to take small positions in a lot more stocks than it does now. "Within a basket of those 0.2 percent positions, my hope is that there will be some home runs," Feingold says.
Whatever reforms are taking place, investor attitudes toward megafunds might be changing. It used to be that the bigger the fund, or the better known the manager, the more investors gave the fund a try. But in 2011, people took more money out of Pimco Total Return than they put in -- for the first time since the fund opened in 1987. Investors also yanked $33 billion out of the Growth Fund of America last year. Kinsey, the financial adviser in Ohio, says his clients aren't questioning him when he sells a fund, regardless of its size. "A fund is there to serve a purpose," he says. "If they stop serving a purpose, we are done with them."
A chart in the print version of "Too Big to Succeed" showed the wrong benchmark for the BlackRock Global Allocation fund; it should have been compared with "world allocation" funds, which it trailed from 2009-2011.