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Theres a limit to how much money even the best fund managers can run. Fidelity Internationals Anthony Bolton has become the latest in an increasingly long line of managers to seek to limit the amount of assets they manage.

In the first half of 2006, Fidelity proposes to divide the assets of the 5.4 billion Fidelity Special Situations fund into two. Bolton, manager of the fund since its launch in December 1979, will run both funds until the end of 2006, after which he will run one of the funds for one more year.

Fidelity has also increased the initial charge on the Special Situations fund from 3.5 per cent to 5.25 per cent on new lump-sum investments outside an ISA to try to slow the inflow of new money. Over the past 10 years, the fund has grown from 543 million in assets.

Barry Bateman, vice-chairman of Fidelity International, said: We believe that by slowing new flows into the fund now and dividing it into two funds, we are taking the right steps to enable a continuation of its long-term performance.

Anthony Bolton admits that, as the fund size rose, he had to introduce more holdings into the portfolio and increase his weighting in larger stocks. To maintain outperformance while managing a larger fund, Bolton says it is essential to have a large team of analysts to support him. It would be near impossible for me on my own to be on top of all the news flow in each of the 200 or so holdings I have. Also, I frequently need to be early in my buying and sometimes selling. I have to consider not just what I want to buy but also the best way to be buying it.

As well as increasing his positions in larger stocks over time, Bolton says he has chosen not to invest in companies with a market cap of less than 100 million. Its true that the bigger the fund, the less manoeuvrable it becomes. However, as a manager I dont tend to make sudden changes to the portfolio, so this doesnt become a major issue.

In trying to cap the size of Fidelity Special Situations, the asset manager has followed the likes of Framlingtons George Luckraft, New Stars Patrick Evershed, First States Angus Tulloch and JO Hambro Capital Managements funds.

Size capping: pros and cons

Intuitively, the capping of fund sizes should be good news for investors. It is argued that a manager of a small fund can put all the assets in his best stock ideas, whereas a lack of liquidity may force larger funds to invest in less good ideas. Furthermore, big funds may have to take larger positions per stock than is optimal, which makes it more difficult for them to get in and out of stocks than for small funds.

But this does not mean large funds necessarily underperform their smaller counterparts. Advantages of large funds include more resources and research as well as lower total expense ratios. Supporters of this view inevitably point to the track record of the likes of Invesco Perpetuals Neil Woodford and Legg Masons Bill Miller. Fidelitys decision to split the Special Situations fund, however, does show there is a maximum size of a fund to maintain outperformance. It poses the questions: what is this size and does it mean you should focus on smaller funds.

There is mixed evidence from academic research on whether small funds outperform their larger counterparts. Lipper has reviewed the academic research as well as studying the performance and size of core, growth and value funds in the US between 1999 and 2001. It says the research provides no consistent evidence of fund size affecting performance.

Andrew Clark, senior research analyst at Lipper, says: Only small cap funds appear to have fund size affecting their performance, and we find smaller is better. The effect seems to be due to liquidity issues.

While our standard model seems to indicate that fund size does affect performance bigger is better among large cap growth funds, we find two other equally descriptive models where fund size does not affect performance. This leads us to conclude that, for large cap growth funds, the evidence for fund size affecting performance is not entirely convincing.

Some managers views

Robert Burdett, co-manager of Credit Suisse Asset Managements multi-manager funds, says fund size has never on its own prompted a decision to sell or not buy a fund. But Burdett says it has been a contributory factor; and that small funds have a better chance of outperforming. As a result of this belief, Burdett and Gary Potter manage the CSAM Incubator fund, which is designed to invest in small and nimble funds.

In the 12 months to 30 June 2005, the top-performing funds in 20 out of 26 IMA sectors had assets of less than 100 million, says Burdett. In the 12 months to 30 June 2004, 18 of the best-performing funds in 26 sectors had assets below 100 million. In the 12 months to 30 June 2003, its 21 out of 26 sectors.

Continuing with 26 sectors, Burdett says in the year to 30 June 2005, 280 funds below 100 million in assets were in the top quartile compared to 160 funds with more than 100 million. In the year to 30 June 2004, 270 funds below 100 million were in the top quartile against 140 above 100 million and it was 226 against 139 in the year to 30 June 2003.

Focusing on 12 IMA sectors, Burdett says 25 per cent more funds deliver consistently above-average returns three years in a row among sub-100 million funds than above. He adds that 30 per cent more funds under 100 milllion are consistently top-quartile three years in a row.

Mick Gilligan of Killik and Co adds that it is important to look beyond the size of the particular fund being analysed. Investors should look at all the assets being run by a manager, which can include funds other than the one youre investing in and pension fund mandates.

Gilligan says the decision on whether a fund is too large to maintain outperformance varies on a case-by-case basis. It can be argued that small funds benefit from greater flexibility. But there are situations where funds benefit from their large size.

Simplistically, if a manager starts buying into a position and the share price continues falling, a large fund has the assets to add to its position and benefit from buying at a lower price. A smaller fund may only be able to buy one or two positions.

The other occasion on which it is beneficial to run a large fund is when managers have identified plenty of investment opportunities. In late 2002, for example, Miller at Legg Mason said valuations were so attractive that he envisaged virtually no limit to the amount of assets he could have managed at that time.

This illustrates that, before size starts affecting performance, the capacity of funds will vary depending on the stock market environment.

It is argued by some managers that large funds can provide greater access to chief executives of listed companies. They argue a significant holding gives them greater insight into a company enables them to talk to management and have more influence on certain changes being made at the company.

Assessing the managers

Investors need to consider whether managers who have outperformed while running small funds can repeat their success with large funds. This can be done by analysing where managers have taken risk to generate outperformance and whether this is sustainable and repeatable as the fund grows in size.

Managers may have outperformed by investing in mid and small caps. But as the fund size grows, they may have to increase weightings to large caps, for example.

Whether managers can maintain performance while their funds grow in size depends on a number of factors. These include the investment style of the manager as well as the stock market and capitalisation size of the companies he invests in. Clearly, large cap funds can grow larger than small cap funds before performance is detrimentally affected.

Funds with a higher turnover of stocks may have a lower capacity of assets. Its argued that the size of a fund is a different issue if there is a 110 per cent turnover of a portfolio in one year than if there is a 20 per cent turnover. Neil Woodfords average holding period for a stock, for example, is three to five years.

If managers take a longer-term and contrarian investment approach, it means liquidity may be less of an issue. If a manager buys when other investors are trying to sell and sells companies when others are buying, it should enable him always to have liquidity in his portfolio