Does the size of a mutual fund matter?

Paul's Answer:

Yes, size matters. But it's hardly the most important factor to consider when you are choosing a fund. It's risky to give blanket advice because there are always exceptions. But here's how I see it.

In a traditional bond fund, big is beautiful. A bond fund doesn't need to be small and nimble. It needs low expenses, and in bond funds, that's a result of a large fund. For instance, the huge Vanguard GNMA Fund (vfiix) has assets of about $12.6 billion and an expense ratio of 0.3, very low. Its low costs have helped it produce above-average performance.

In small-cap and micro-cap stock funds, small size is an advantage. Whether it's an index fund or actively managed, huge size makes it tough for a fund to buy small companies without artificially driving up their prices. Fidelity's gigantic ($7 billion in assets) and actively managed Low Priced Stock fund (flpsx) is an exception; it owns hundreds of stocks, has had good performance and its expense ratio is still below average at 0.95 percent. The median market capitalization of its portfolio is $575 million.

The DFA 9-10 Small Company Fund (dfscx) (an index fund) has assets of $1.3 billion and expenses of 0.59 percent. It's truly a micro-cap fund, with a median market cap of $134 million, according to Morningstar data.

And near the bottom of the size range is the tiny ($26 million in assets) Wilshire Target Small Company Value Fund (dtsvx), which is included in one of our Model Portfolios available at www.FundAdvice.com. This fund has an expense ratio of 0.85 percent. While this fund is plenty small enough to buy stocks of micro-cap companies, its median market cap is reported as $801 million.

In general, active portfolio managers sometimes have more difficulty if the size of their portfolios increases rapidly. A fund with $500 million in assets, for instance, may achieve an impressive track record by nimbly buying and selling stocks in quantities too small to affect the market price.

But if that track record led to a surge of money flowing into the fund from new investors, the manager could find it necessary to start buying stocks of larger companies - so all the new money can be put to work. Moving into larger companies is one example of what's called "style drift." A fund in this position may be successful. But it will no longer be doing what it did when it created its historical track record.

And if a micro-cap fund over time becomes a mid-cap fund, it will likely produce mid-cap returns, not micro-cap returns.

To sum it up, I wouldn't worry too much about the size of a mutual fund. It's more important to focus on the turnover ratio, the tax efficiency, expenses and - most important of all - what type of asset the fund invests in. If you get all those things right, size won't matter so much.