Limits to growth
When fund size starts to affect returns
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Ferdinand Magellan was the first explorer to circumnavigate the earth. The Magellan Fund, named after him, has been all over the place too just like its namesake. Apparently launched as a “Spaghetti against the wall” fund by Fidelity in 1963, the fund had a modest $20 million in AUM when Peter Lynch took over as its manager in 1977. In his 13 year tenure, the fund’s AUM grew to $14 Billion, while averaging a 29% annual return! After Lynch retired in 1990, the fund continued to grow based on its legendary reputation and had more than $50 Billion in AUM at one point.
But Magellan’s subsequent stint wasn’t as impressive. When Bob Stansky became fund manager in 1997, more than $3.5 billion was withdrawn from the fund in just the first month. Fidelity closed the fund to public investment believing that the size of the fund was making it difficult to beat the market. Its strategy mirrored this belief – the active share (proportion of the fund’s investments different from the benchmark) dropped from more than 75% in 1995 to close to 30% in 2003, so much that the term “closet indexing” was coined to describe Magellan’s behavior of closely tracking the S&P 500 while charging fees for active management. Despite tracking the index so closely, Magellan returned 238% under Stansky, compared to the S&P 500’s 274% in the same period!
The problem of low active share and fund managers charging high fees while tracking the index is a known problem, but it’s a symptom of a much larger issue: As a fund grows popular and inflows inflate its AUM, does it lead to a decay in performance? To put it simply, does size erode returns?
It turns out that there’s a lot of research on this topic. In this article, we will be exploring:
How is fund performance correlated with size and fund inflows?
At what threshold does fund performance start deteriorating?
What factors make it harder for bigger funds to succeed?
Which metrics can help you change your strategy before returns decay?