Bigger isn’t better

It can seem that the bigger a mutual fund gets, the better, but that’s not the case. The vast majority of managed stock funds fail to beat the overall market over long periods — and that’s partly due to their size. (According to the folks at Standard & Poor’s, for example, as of the end of 2016, fully 85 percent of all domestic large-cap stock mutual funds underperformed the S&P 500 over the past 10 years.)

Managers of huge funds face challenges. They may not be able to invest more than 5 percent of their fund’s value in any one stock, for example, no matter how confident they are in it. They may also keep 5 percent or so of the fund’s value in cash, to cover investors’ withdrawals. That’s good, but those dollars can be a drag on the fund’s performance.

Consider Fidelity Investment’s massive Contrafund, with its recent net asset value of $116 billion. It recently had a whopping $1.4 billion invested in Netflix shares, but that amounts to less than 1.3 percent of the fund’s net assets. When you’re invested in hundreds of companies, the impact of standouts is diluted by the many less-stellar performances.

Even if a manager wanted to spend 10 percent of a $116 billion fund’s value, $11.6 billion, on one company, he’d run into problems. Buying many shares would drive the stock price up before he was finished buying. Also, imagine that he was very bullish on, say, the jewelry company Tiffany. Oops. Its entire market value is around $11.6 billion. He can’t buy entire companies. If he’s limited, as many managers are, to not buying more than 10 percent of any company, he can spend only about $1.16 billion on it. It’s hard not to spread yourself too thin when $1.16 billion is a drop in your fund’s bucket.

For most investors, index funds such as those based on the S&P 500 are the best solution. To see managed and index funds we have recommended, try our “Rule Your Retirement” newsletter for free at fool.com/shop/ newsletters.