Contradictions in Investing: When Big Is Bad

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Life is full of contradictions: Think of the adages "out of sight, out of mind" and "absence makes the heart grow fonder." It's the same with investing.

Consider mutual funds. You want to invest in successful ones, and many of the most successful ones are big, because their success attracted many investor dollars. But being big can hurt a fund's performance when its managers have trouble finding enough great investments for all that money. And despite all that, some big funds still do manage to perform well, and better than many smaller peers. It's enough to make your head spin!

Let's look at these issues a little more closely in the context of large mutual funds.

Complications
If you were charged with investing a big mutual fund's money and turning in strong performances, you'd have a hard time of it, as mutual funds generally have strict rules that can make effective investing difficult.

For starters, you'd likely have to keep 5% to 10% of the fund's value in cash, to cover withdrawals when people sell shares. For example, the American Funds Growth Fund of America (AGTHX), with a whopping $133 billion in assets under management, recently had about 8% of its assets in cash. Money sitting in cash is going to have a hard time even keeping up with inflation in this low-interest-rate environment, so that money may well lose purchasing power over time.

Limitations
You also probably wouldn't be able to invest more than 5% of the fund's value in any one stock, limiting you to no fewer than 20 stocks. Many large funds actually invest in several hundred stocks. The Growth Fund, for example, holds stock in about 300 companies. Its biggest holding was recently Apple (NAS: AAPL) , representing about 4% of the fund's assets. With its wildly successful iPads and iPhones, Apple has served the fund well, and among other things its international expansion bodes well for the company. But only 15 of the fund's holdings have a weighting of 1% or more of the fund's assets. It's hard for even a very strong performer to make much of a difference for a fund if it makes up less than 1% of it.

Consider three companies that you might be eyeing for your own portfolio: Corning (NYS: GLW) , Las Vegas Sands (NYS: LVS) , and Sirius XM Radio (NAS: SIRI) . You might like Corning because of its intelligent stock buyback plans now that the stock is cheap, and for its growing market share in the LCD glass market. Las Vegas Sands might appeal because of its presence in the rapidly growing gambling venue of Macau and its booming Singapore property, among many others. Sirius XM Radio is intriguing, too, with its two new satellite receivers and rising free cash flow.

Those who want to invest in the three companies individually would have to follow them closely, as with most stock holdings. It might be tempting to let a mutual fund such as the Growth Fund own those stocks for you, but they're probably not going to move the fund's needle much, no matter how well (or poorly) they do. Las Vegas Sands makes up just 0.47% of the fund, while Corning represents 0.40% and Sirius XM Radio just 0.12%. Remember, they're three of 300-some holdings.

Note, too, that huge funds tend to hold stock in huge companies. If you're drawn to the potential of small caps, a big fund might not serve you well. Even if a big fund's manager loves Geron's (NAS: GERN) work in stem cells and its anticancer therapies, the company has a market capitalization of just $335 million. When 1% of the Growth Fund represents $1.3 billion, taking even a 10% stake in Geron -- which would be a major step that most mutual funds would avoid -- would hardly move the needle for fund shareholders.

Rule buckers
Of course, every rule has its exceptions, right? As a reminder that we should never rule out a fund just because of its size, there's Fidelity's Contrafund (FCNTX), with around $75 billion in assets and market-beating returns over the past three, five, 10, and 15 years. It's beating the market so far this year, too, perhaps because it has made some big bets among its 440 holdings, with 42% of its assets in its top 20 stocks. Those include Visa (NYS: V) and McDonald's (NYS: MCD) , respectively up 17% and 22% over the past year. Visa has been doing so well that it recently hiked its dividend by 47%, and McDonald's has been boosting sales and profits substantially in Asia.

What to do
When seeking great funds, we need to keep in mind that massive size can be a problem or at least a challenge for mutual funds. It can be smart to favor smallish funds with strong records, but don't automatically rule out big funds. And above all, consider fees along with performance. The Growth Fund, for example, charges a 5.75% front-end load, lopping off a big chunk of your investment before delivering returns that don't always beat the market.

Looking for some promising investments?Read this free reportfrom The Motley Fool to find the names of five stocks we own that you should, too.

At the time this article was published LongtimeFool contributorSelena Maranjianowns shares of McDonald's, Corning, and Apple, but she holds no other position in any company mentioned.Click hereto see her holdings and a short bio. The Motley Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of McDonald's, Visa, Apple, and Corning, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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