ONCE HOT, THEY’RE TOO FAT TO DANCE WITH: INVESTORS DUMP<p>FORMER SKYROCKETS WHEN PERFORMANCE FALLS AS ASSETS RISE

Fidelity Investments isn’t the only company with fat mutual funds that could stand closing the kitchen to new investors.

Small- to mid-cap growth funds like Brandywine, PBHG Growth, Kaufmann and Aim Constellation are among those that might have become too big for their britches, new findings suggest. Though none of these funds plans to stop accepting new customers, all are underperforming their peers after receiving major inflows of assets.

In fact, they might not have to close themselves; investors are taking care of the size issue for them, yanking out as much as $184 million to $476 million from each just through February. Small and mid-cap growth funds – with median market capitalizations from $250 million to $5 billion – can lose their performance edge after growing past as little as $150 million in assets, says a a broad-based Morningstar Inc. study of more than 600 funds.

Take $8.1 billion Brandywine. Its three-year annualized return of 22.8% through February put it in the bottom half of mid-cap growth funds, along with $13.6-billion Aim Constellation and its 22.7%. return. The $6 billion Kaufmann fund’s 25.1% three-year return puts it just within the top third of small-cap growth funds, but returns have been steadily eroding compared with peers’. All three racked up outstanding returns when they were smaller, and sport 10-year records in the top 5% of comparable funds.

“For the most part in this industry, the interests of the manager are at odds with the interest of the shareholder,” says John Bogle Jr., director of portfolio management at Numeric Investors LP, who analyzed the impact of fund asset size on trading costs within his own company and found that fund bloat occurs everywhere. “It happens more in momentum-style funds than value, more with small-cap funds than large-cap, and it matters more with higher turnover funds than those with low turnover,” he says.

bigger, not better

The latest research pokes a hole in the argument that as a fund grows, shareholder
s benefit increasingly from operating efficiencies.

“We see good economies of scale, but the relationship starts to flatten after $1.5 billion in assets, especially among growth funds,” says James Raker, senior research analyst at Morningstar. Its study found that returns of large-cap growth funds are most likely to suffer as the funds grow. Analysis of Morningstar data suggests Fidelity might well add the $10.2 billion Growth Company Stock fund, a large-cap growth fund, to the three it plans to close to new investors this week – the $40.9-billion Growth & Income, $32.2-billion Contrafund and $11.6-billion Low-Priced Stock. The fund has had net outflows of $507 million through February.

Though the studies don’t say how to determine when a fund grows too musclebound to deliver market-beating results, they do reinforce the point that fund size counts.

The dropoff in performance seems to follow asset growth and could be attributable to a change in investing style – a mid-cap manager being forced to buy larger companies – or a manager’s style falling out of favor.

Yet Mr. Bogle says some portion of the performance fall-off can be traced to trading costs, which increase as a fund grows in size. These include not only brokerage commissions, but the movement of the market price of a stock up or down when a manager tries to accumulate or sell off a stock.

Though fund managers increasingly acknowledge that size has the potential to hurt returns, many say they don’t believe it’s a problem for their own funds.

“The bigger you get, the more challenging it is to manage money effectively,” says Foster Friess, lead manager of the Brandywine fund.

diluted impact

Yet Mr. Friess says he has solved that problem by hiring extra stock pickers and organizing them into teams who run eight $700 million pools. Still, the fund went from the top 4% of mid-cap growth funds over 10 years to the bottom half over the three years through February, says Morningstar.

“Size isn’t an issue with us,”
says Mr. Friess. “We weren’t clever enough to figure out what was going on in Asia.”

Fund industry observers aren’t buying it. “He’s doing nothing to mitigate the size issue,” says John Markese, president of the Chicago-based American Association of Individual Investors. “The best funds grow big because they have one manager who has bright ideas. If you break that up and have a bunch of sub-managers, you’ve lost the force that created the size to begin with.”

The picture at Pilgrim Baxter & Associates’ PBHG Growth fund is similar. It swelled 181%, or more than $3.6 billion, in 1996, and finished the year 6.5 percentage points behind mid-cap growth peers.

“I have a hard time drawing any correlation between size and investment performance except at the extremes,” says manager Gary Pilgrim. “We are always among the best or among the worst performers,” depending on the market environment for small high-growth companies.

The link between size and returns is acute among small-cap “momentum” funds that chase growth. Kaufmann, still the best of small-cap growth funds in the 10-years ended Feb. 28, ranks among the worst 25% over 12 months. “Our legitimate feeling is that we don’t think the size has impacted performance,” says co-manager Lawrence Auriana.

Still, many financial advisers worry about asset growth. Says Jean Sinclair of Arcadia Financial in San Diego: “I wish certain funds would close, but I don’t want them closed to my clients that come on board.”