Morningstar Director of Manager Research Russel Kinnel developed a measure he believes can start to answer the questions: “Has asset growth altered your fund's strategy? Has it done so to the point where it starts to hurt performance?” Kinnel explains the “bloat ratio”:
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. 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.
Not surprisingly, Kinnel finds that small-cap funds are the most sensitive to bloat. Compared to small-cap funds in the most bloated decile, those in the least bloated decile had higher pre-expense annualized returns (11.51% versus 10.04%), higher information ratios (0.31% versus 0.23%), higher success ratios (43% versus 35%), and higher Morningstar ratings (3.04 stars versus 2.69 stars). Kinnel finds some predictive power for the bloat ratio in mid-caps (albeit with limited impact), and no apparent impact in large-cap funds.