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Investing

When Big Isn't Better

Be on guard for asset bloat. It can cramp a manager's style.

From 1996 through 2001, State Street Aurora threatened to become the Barry Bonds of funds. The fund, which invested mainly in small companies, beat the Russell 2000 index five times, each time by at least 12 percentage points -- and twice by 40. During the period, assets grew from $1 million to $1.7 billion. Now called BlackRock Aurora, the fund has since edged the Russell twice and trailed it slightly twice. Clearly, it is no longer the home-run hitter it once was.

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When it comes to funds, bigger is not necessarily better. Asset bloat is particularly problematic for funds that invest in small companies. Bloat makes it harder for managers to buy or sell big positions in smaller companies without affecting their prices. There are now 71 small-company funds with more than $1 billion in assets, says fund researcher Lipper.

Unpleasant options

Fund managers can respond to asset growth in several ways, but each has its own shortcomings. They can, for example, take smaller positions in more stocks. But holding too many stocks "essentially dilutes a fund's best picks," says John Seitzer, a financial planner in Leawood, Kan., and a former fund manager. They can invest in larger companies, but that changes the nature of the fund.

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There are no firm rules about what makes a fund too large, but you should pay heed if assets exceed $1 billion. FMI Focus is a poster child in this regard. It returned 48% in 2003, slightly better than the return of the Russell 2000, and ended the year with $1.2 billion in assets. In 2004, the fund lagged the Russell by 11 percentage points, and last year it barely topped the index. So FMI Focus bears watching. And so do all of the funds in the table above (for our favorites, see The 25 Best Mutual Funds).

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Another way a manager can respond to bloat is to allow a fund's cash level to rise. For example, manager John Rogers let cash in Ariel Fund rise last year to 20% of assets because he couldn't find enough attractive small companies.

Rogers then changed his strategy to allow for more investment in midsize companies, which helped reduce the fund's cash position to 2%.

Diagnosing asset bloat involves more than looking at a fund's size. Many managers also handle separate accounts or run other funds with similar investment styles. So the manager of an $800-million fund may also control $2 billion in other venues.

The ultimate response to asset bloat is to close a fund to new investors. According to Morningstar, 294 funds aren't accepting cash from new clients; of those, 91 specialize in small firms. T. Rowe Price New Horizons has closed several times in the past. Spokesman Steve Norwitz says that the decision is a function not just of size but also of available opportunities. Chuck McQuaid, manager of Columbia Acorn, the largest small-company fund still open, says that with the help of 20 analysts, he can still find attractive stocks.

Both New Horizons and Acorn returned about 30% annualized over the past three years, handily beating the average small-company fund. So bloat doesn't doom a fund to mediocrity. All things being equal, however, it's preferable to invest in smaller small-company funds than in bigger ones.

Big little funds

These are the ten biggest small-company funds that are still open to new investors.

FUNDASSETS*
(in billions)
Columbia Acorn$17.9
Franklin Small-Mid Cap Growth8.2
T. Rowe Price New Horizons7.0
Royce Total Return5.8
Ariel Fund4.8
Fidelity Small Cap Stock4.6
Oppenheimer Main St Small Cap3.9
Oppenheimer Small & Mid-Cap Value2.6
BlackRock Aurora2.4
Fidelity Small Cap Independence2.2

*As of February 28. Source: Standard Poor's.

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