The Real Returns posted an interesting list of the 20 largest mutual funds, and I thought it was interesting, so let me just mention some things about mutual funds.

A larger mutual fund is typically an indication that the fund is perceived as more desirable, and as a result investors put more and more money into the fund. However, this trend can produce some undesirable side effects.

For one, larger funds are not as agile. Alerts setup on the floor notify traders if unusually high sales are occuring on an individual security. Sales largely or consistently in excess of this limit can cause rapid sell offs that result in lower prices. Fund managers desperately want to avoid this if they have positions in a security of 10s of millions of dollars. As a result a large fund could take weeks to sell of their entire position, resulting in sub-optimal selling prices.

Additionally, when a fund becomes too large, they can end up losing the edge that made them so popular in the first place. Because many fund managers are paid based on total assets managed, as funds become larger they become less aggressive in order to avoid rocking the boat. Most of the Real Returns list are returning under 7% for the last 5 years, with only 4 breaking 10%.

In its December 2005 issue, SmartMoney demonstrated some examples of large funds that are underperfoming and smaller funds offered by the same firm that can produce better results. One example was the Putnam Growth & Income fund (PGRWX), which holds $16.3 billion in assets and had a paltry 5-yr average return of 2.8%. By contrast the Putnam New Value fund (PANVX) has only $1.9 billion in assets and performed with a more solid 5-yr average return of 8.2%.

When shopping for a new fund, it isn’t necessarily advantageous to buy the biggest or most popular. Look at companies with solid track records of performance, and find funds managed by those firms that are growing but not excessively large. Those may well turn out to be the smartest money around.