Are your client’s fund holdings too bloated?

Are your client’s fund holdings too bloated?

Are your client’s fund holdings too bloated? It’s a question that Morningstar Director of Research Russel Kinnel asks himself when examining whether the growth of a fund’s assets has altered the investment strategy of a particular fund, a good predictor of potential underperformance in the future.
 
Kinnel uses a term he calls the “bloat ratio” which examines the liquidity and trading costs of a mutual fund over the long-term.
 
“It has merit both for descriptive and predictive power,” Kinnel wrote in a recent article. “It helps you understand the fund's bloat relative to peers. In addition, changes in the bloat ratio can signal changes in strategy, including those brought on by asset bloat.”
 
You can read the entire article here.
 
To calculate the bloat ratio of a mutual fund you need four basic ingredients: the turnover ratio, the fund’s top 25 holdings, the number of shares the fund owns in each of the 25, and average daily trading volume of the top 25.
 
You’re not done just yet. You still need to make a few mathematical calculations before arriving at an answer but it won’t take too much heavy lifting so advisors can relax.
 
“First, divide the average daily trading volume by the number of shares owned by the fund. That tells us how many days' trading volume the fund owns. The bigger the number, the less liquid the position. If a fund owns, say, 10 days' trading volume of a stock, it might take months to get out without crushing the price,” wrote Kinnel. “Then, we take the average of the fund's trading volume figures and multiply by the turnover ratio. (That 10 days' trading volume position might be manageable for a fund with 10% turnover, but the trading costs will likely be steep for one with 100% turnover.) That gives us the bloat ratio.”
 
Kinnel looked at large-cap, mid-cap, and small-cap U.S. mutual funds calculating their bloat ratios over the past five years comparing it to annualized five-year returns.
 
Which stocks did the best under the bright lights?
 
Small-cap stocks benefited the most from lack of bloat where the least-bloated small caps generated pre-expense returns of 11.51% on an annualized basis versus 10.04% for the most-bloated small caps.