Fund Size Problems: Why Bigger Mutual Funds Aren't Better

Common Sense on Mutual Funds | John C. Bogle | ISBN: 9780470597484

← Previous: Closet Indexing | Next: Taxes and Mutual Funds →

“Nothing succeeds like success.” Everyone knows that one. Bogle flips it for Chapter 12: “Nothing fails like success.”

Mutual fund assets went from $34 billion to $2.8 trillion in two decades when he wrote this. The industry became a financial behemoth. And Bogle argues that growth didn’t help investors. It hurt them.

Funds now own a huge chunk of corporate America

In 1982, mutual funds held 2.8% of U.S. stocks. By 1998, that hit 21%. Add separate accounts managed by the same firms and you’re at 33%. Funds weren’t just investing in the market. In a real sense, they were the market.

Portfolio turnover hit nearly 90% per year. Funds accounted for maybe half of all stock trading. When you’re that big and that active, you can’t move without moving prices.

Bogle found something curious in the data. Funds underowned the biggest stocks (Coca-Cola at under 5% ownership vs. 21% average). Those underowned giants led the 1996-1998 bull market. Active managers, scared of lagging the index, rushed to buy them. The index fund boom may have been driven more by active managers panicking than by index funds themselves.

The industry can’t beat the market anymore (and maybe never could)

Here’s Bogle’s logic, and it’s hard to argue with. A group owning 3% of the market might outperform. A group owning 21%? Virtually impossible. At 33% doing half the trading? “Gone with the wind.”

From 1945 to 1975, equity funds lagged the S&P 500 by 1.6% per year. By 1981, that gap shrank to 0.8%. Then from 1981 to 1998, it widened to 3.7% annually. Rising expenses and turnover ate the returns.

The fleet-footed cheetah became a lumbering elephant. Bogle’s 2009 update was worse: assets peaked at $6.9 trillion in 2007 before falling back. Fund ownership of U.S. stocks hit 29% at the peak.

He also admitted he was wrong about one thing. He thought fund ownership would push companies to focus on shareholder value. Instead, the “agency society” let managers run companies for themselves. Executive pay exploded. Earnings got managed. Bad mergers happened. Speculation beat investment.

Giant funds lose their edge

Bogle tracked five of the largest actively managed equity funds. From 1978 to 1982, they beat the S&P 500 by 10 points per year with just $500,000 in assets per $1 billion of market cap. From 1994 onward, with $3.5 million per $1 billion of market cap, they lagged by 4+ points per year.

Sevenfold increase in relative size. Fourteen-point swing in performance. That’s not coincidence.

Three reasons size kills performance

1. Shrinking universe. A $1 billion fund can pick from ~3,000 stocks at a 2% max position. A $20 billion fund? Maybe 470. At $5 billion with stricter ownership limits? 257. That’s a 92% reduction in choices.

And the “fund” isn’t even the right unit. Bogle shows a $75 billion fund that “closed” at $60 billion but had sister funds and pension accounts holding the same stocks. Effective size: $200 billion.

2. Higher transaction costs. Bogle’s son John Bogle Jr. studied 20,000+ trades at Numeric Investors. Value stock trades cost 0.6% of trade value. Small-growth trades: 1.8%. Trades equal to two days’ volume: 2.3%. He closed two funds at $100 million each. That’s discipline.

Buffett said 75% of Berkshire’s performance decline came from size. In the 1950s, he earned 60%+ annually on tiny stocks. At $64 billion, he dreams about beating the market by 3 points.

3. Process over judgment. Big organizations replace individual managers with committees, org charts, and red tape. Roger Lowenstein put it well: picking stocks is like writing stories. It works best in small groups buying only their best ideas. You can’t order dozens of managers to outperform.

Why do funds keep growing?

Because managers love it. Advisory fees scale linearly with assets. Profits scale even faster because economies of scale go to the adviser, not the shareholder.

Bogle proposed five fixes: lower turnover, close funds to new money, add external managers, cut base fees and add performance-based incentives, offer low-cost index funds. A decade later, almost none of it happened. Turnover went up. Fund closures stayed rare. Incentive fees didn’t appear.

My take

This chapter changed how I look at fund flows. When I see a hot small fund getting millions in new money, I don’t think “smart money is piling in.” I think “this fund’s best days are probably behind it.”

The Magellan Fund story is the classic example everyone cites. Great when small. Mediocre when huge. The pattern repeats everywhere.

Bogle’s “real size” concept is underrated. Always check the fund complex, not just the fund. If three funds at the same company all own Microsoft, the biggest fund’s size problem is worse than it looks.

For individual investors, the practical takeaway is simple. Prefer smaller funds with genuine strategies, or skip the game entirely and buy an index fund where size is a feature, not a bug. A $500 billion S&P 500 index fund works fine because it’s not trying to outsmart anyone.

Big active funds trying to be clever? That’s where “nothing fails like success” lives.