Most of us have a secret wish: We'd like to find the perfect little mutual fund.

We can close our eyes and imagine this fund. It will have good performance, year after year. It will never suffer from market downturns. It will be interesting. But it will never be scary.

And it will eventually make us rich.

Virtually no one will know about this fund because it will be our wonderful little secret, tucked away with the phone number of our favorite little restaurant.

That nearly universal wish is our downfall.

The wish supports countless investment newsletters, an entire array of glossy personal finance magazines, and thousands of hedge funds. It positions us to be the victims of good marketing.

It's also the reason we now have 23,000 mutual funds, up from a mere 486 (not counting 159 money market funds) only 25 years ago. Indeed, according to the Investment Company Institute, the entire industry had only $55.2 billion in assets in 1981, excluding $181.9 billion in money fund assets.

Today, seven individual funds have at least $55.2 billion in assets. The largest of them, American Funds Growth Fund A shares, has $77.4 billion in assets under management.

So here's a rude question. Will we be rewarded by searching for that perfect little fund? Or will we be better off with the big fund right under our nose?

To test this, I divided the Morningstar mutual fund database into two parts, the 25 largest domestic equity funds and the 10,023 domestic equity funds with $500 million or less in assets. The 25 largest funds had assets of at least $29 billion.

And guess what? The big funds won. And they didn't win in just a few time periods or by tiny margins. The big funds swamped their competition. On average, they did better regardless of the investment period--- 12 months, 3 years, 5 years, 10 years, or 15 years. (See table below)

The Triumph of Big Funds over Small Funds

This table compares the annualized performance figures for two samples of domestic equity funds, the 25 largest and the 10,000 smallest, over the period ending August 31, 2006.

Fund Group

Avg. Exp. Ratio

12 months

3

years

5 years

10 years

15 years

25 Largest

0.53%

9.56%

12.34%

7.05%

10.35%

11.74

10,000 Smallest

1.54

6.87

10.82

5.49

7.88

9.36

Source: Morningstar Principia database for August 31, 2006

Needless to say, some caveats are due. The most important is that our figures have a chicken/egg problem. Did the largest funds do well because they were so large? Or did they become large because they did so well?

In fact, most the 25 largest were already large, well established funds 15 years ago. Only 4 don't have 15 year track records and all four are index funds. On the other hand, only 363 of the small funds have 15-year track records and only 1,559 of the 10,000 have track records of at least 10 years.

One advantage the large funds have is lower expenses. With an average net expense ratio of only 0.53 percent--- only a small premium over index funds--- they gain a full percentage point each year over the 1.54 percent average net expense ratio of the 10,000 smallest funds.

The large funds also have a lower portfolio turnover rate, only 25 percent compared to the 86 percent average turnover rate of the smallest funds. As a consequence, the large funds have materially lower transaction costs. This benefits the shareholder even if the fund is held in a tax deferred account--- but is an even larger benefit if the fund is held in a taxable account.

Finally, the large funds have achieved higher returns with less risk. While the standard deviation (a measure of market risk) of the average small fund is 15 percent over the last 5 years, the corresponding figure for the largest funds is only 12.1 percent.

Does this mean you are guaranteed to enjoy superior performance by limiting your choices to the largest funds?

Sorry, no. Had you hung in with Fidelity Magellan, now the 10th largest domestic equity fund, you would have been disappointed. There is no lead pipe cinch in mutual fund selection.

That said, selecting from the largest funds will improve your odds substantially -- and that's what investment decisions are all about, improving the probability of better results.



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Scott Burns is the Chief Investment Strategist for AssetBuilder, Inc. and his columns are syndicated across the country. Readers can register at www.scottburns.com and post questions/comments or send directly to scott@scottburns.com. Questions of general interest will be answered in future columns and remember to click on the "Blog" navigation to see other columns. All comments are welcomed and appreciated.