Mega funds hold a large share of US investors' capital. But does their performance justify their popularity? David Masters reports

Does size matter? In the dynamic mutual fund market of the US, many commentators believe that the size of a mutual fund is important in relation to performance. There is not, however, any broad rule - 'mega funds are good' or 'mega funds are bad'. The relationship between size and performance depends very much on style and objective. For instance, in the US equity fund universe the five largest US mutual funds all rank in the top quartile when measured against other US equity funds over the last year.

Overall, there are 59 US equity-invested US mutuals with more than $5bn under management. The largest is the celebrated Fidelity Magellan, with $65.9bn. Combined, these funds represent around $880bn under management, 49% of the money invested in US equity funds, but less than 3% of the availabl e funds. These behemoth funds thus represent a considerable concentration of US investors' capital.

To understand whether or not this concentration is justified, it is important to evaluate the types of investment these funds represent. Mostly, the behemoths are growth or growth and income funds. Therefore, they tend to represent 'core portfolio' holdings for their investors, and have seen tremendous inflows from 401K investors. In the growth and income sector, the fund colossi have, as a group, outperformed the sector overall this year to date, and over one, three, five and 10 years. They have also provided more optimal risk returns. These large funds are also notable for the consistency of their style and approach. Style drift is often negligible at the most successful of these funds. The focus tends to be on large capitalisation stocks, hardly surprising given their size, with a blend or value approach.

Fidelity Magellan, the most famous behemoth, is also one of the least consistent. As famous now for its manager changes as for anything else, Fidelity has undergone a number of style shifts. Up to 1982 the fund was a small-medium capitalisation growth fund, but it has since moved and now resides in the 'large cap blend' category.

A major criticism of these funds is that they offer less flexibility than smaller funds because the simple task of moving assets in that bulk reduces the manager's nimbleness. There may be some truth in that, but the largest of the funds (and therefore surely the most successful) are, as we have seen, generally consistent and have quite low turnover. The large fund managers' defence would be that there is no need to keep chopping and changing the fund's holdings, if it has a successful and proven approach.

The recent market volatility goes someway to reinforcing this. Between January 9 and July 17, the S&P 500 Index rose by 28.87%, a considerable bull period. During this time, the average growth and income fund rose by 22.09%. The behemoth funds marginally trailed the pack, averaging 21.76%. Of course, the markets promptly did an about-turn at this point. Between July 17 and the end of August, the market declined by 19.13%. Growth and income funds, as a whole, dropped by 19.44%. The super-size funds actually fared slightly better, their average decline of 18.58% actually outstripping the index. Four of the largest five funds also recorded even better gains than that, the exception being Vanguard's 500 Index fund, which naturally fell in line with the benchmark it tracks. Since then, the market has offered a recovery of sorts, gaining 12.02%. The 11 largest growth and income funds all comfortably outperformed the sector average in that time.

This is not to say that biggest always means best. Whilst large equity funds tend to do better investing in large companies in the largest equity market in the world, there are times when small can be beautiful. In the smaller and aggressive ends of the US market, smaller funds have tended to do best. For example, in the small companies sector, eight out of the top 10 performing funds over the past three years have less than $500m under management.

In internationally invested equity funds, where assets under management are traditionally much less than with domestic investments, there is less obvious correlation between size and performance. Obviously in such a studiously parochial environment, an international fund will need to have had some lengthy periods of top-ranking performance to have generated sufficient interest to see assets under management rise above the $1bn mark. Amongst these are EuroPacific Growth, managed by American Funds, with just over $18bn under management and New Perspective with $17.7bn. Both are generally above- average performers in their peer groups.

A recent trend with US mutuals is funds closing to new investment once a certain asset size is reached. There are benefits for managers as it allows them to control inflows far more easily. In the past few years as fund investment has boomed, huge inflows to successful funds have been perceived as a problem, if only by the portfolio manager responsible for allocating the money. One fund that recently closed was the Weitz Hickory Fund. A mid-cap fund with a concentrated portfolio (another recent fad in the US), it had been generating some headline-making performance. During the previously mentioned 1998 bull period, the fund returned 47.4% against an overall 20.94% for all US equity funds. It followed this with a 15.7% decline during the correction period - again, much better than average. It was during this period that the fund closed, having risen to just under $500m under management, still below average by US standards. Nevertheless, the fund has faltered alarmingly. Whilst the market has risen by more than 12%, Weitz Hickory has dropped by 6.83%, making it the tenth worst performing US equity fund during the recovery period. There are occasions when more most definitely means less.

David Masters is with Standard & Poor's Micropal in Boston

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