I had a recent discussion with a friend who has worked in the mutual funds industry for a number of years in a number of capacities, ranging from finance to marketing. I had a pretty simple question to ask him: How does the mutual fund industry make money?

Turns out that the fees we all know about are only part of the picture. One percent here and $10 there may not seem like much, but scale that to many thousands of customers and transactions per year for an average-sized fund, and the fees start to add up.

Another issue to consider: A fund with $500 million in holdings may have two fund managers, and two analysts. A fund with $5 billion in assets will probably have two fund managers and analysts as well, but every year will gather far more in fees than the $500 million fund. In other words, even as a fund's customer base swells, the management team will not. While there will be increased overhead to deal with various administrative costs, most of the extra money the fund company pockets in increased levels of fees is profit.

Despite the allure of attracting more new customers and increasing fee revenue, there is also the danger in a fund growing too big. Take Fidelity Magellan. You may remember what happened in the 90s. The fund performed well, attracting lots of new customers, which helped boost fee revenue but also led to the fund ballooning to several tens of billions of dollars in assets. The fund became sluggish. It had too much money on hand, and not enough attractive targets to buy in relatively sufficient quantities. Furthermore, buying or selling assets caused major fluctuations in the market. Performance began to lag, and then Magellan wasn't as sexy anymore.

Fidelity has become much more careful with fund inflows. Popular, well-performing funds frequently turn away new customers when assets rise to a certain level. This has happened with Low-Priced Stock and International Small Cap, among others. But Fidelity, being what it is, never turns away customers for long -- it will either steer them toward other offerings, or create a new fund with a similar focus -- such as International Small Cap Opportunities (see my earlier post about this fund).

This may be great for Fidelity, but potentially bad for investors, who might have hoped to get a piece of a successful fund run by a savvy management team, but instead get a piece of a fund with only a similar sounding name and a similar market focus, but a management team who may not have the same track record or investment strategy.mortgage calculator