Stuart Alexander, managing director, Gemini Investment Management

Big funds can become unwieldy

A ‘Goldilocks’ situation is needed when it comes to fund size. Too small and the risks of investment concentration and high costs start to appear. Too big and you can get the drag effect of being too diversified. As many commentators make clear, the ‘supertankers’ can become unwieldy.

As the industry consolidates the buying model through fewer buyers and potentially fewer platforms, this will only exacerbate the situation.

Andrew Smith, head of research, Momentum Global Investment Management

Capacity versus strategy

It is impossible to cast a broad brush and say all funds over £3bn risk blowing up. Capacity varies significantly across asset classes. Global government bonds and UK smaller companies have differing levels of liquidity, so managers operating within these asset classes will have different levels of capacity.

Even within an asset class, capacity is impacted by each manager’s individual strategy. A high turnover growth strategy will have lower capacity than a buy-and-hold contrarian value strategy. 

Furthermore, each manager’s level of concentration impacts their capacity. A manager who has a more diversified portfolio can generally manage more assets.

There is no easy way out on this topic. Instead the key is to truly understand each manager you invest in and the asset class they operate within to determine their capacity. Then be prepared to divest from managers as they approach this level.    

Jon Beckett, UK research lead, Association of Professional Fund Investors

Margins replaced by scale

Even referring to funds as ‘blockbusters’ simply underlines the dysfunction in our industry.

The asset management model has been built on the premise that ‘big is best’, and we have seen a rapid concentration of assets since the credit crisis, through sales flow herding and merger and acquisition activity. Fund houses are attempting to replace margin with scale in order to protect and grow earnings.

However, the emergence of oligopolies is not only bad for long-term competition, but also the investor. Meanwhile, ‘supertanker funds’ are particularly vulnerable to liquidity risk when the trading depth of the market surrounding narrows.

That risk then varies depending on the investor base, the more retail holders in a fund the more likely it will begin to herd. Large redemptions tend to correlate to periods of market stress and illiquidity, and can become a perfect storm.

Peter Askew, co-manager, T. Bailey Growth, Dynamic, and Defensive funds

Becoming ‘Too big to succeed’

Funds can undoubtedly become ‘too big to succeed’. The point at which size has a detrimental effect on the ability to generate returns will depend on the investment strategy.

For example, a large-cap equity fund may still be run effectively at a significantly greater size than a small-cap mandate. But the point is, at a certain size, many funds effectively become passive. However good the manager, their ability to manoeuvre, to actively manage, will be affected by the scale of the assets they are handling. And returns will reflect this.

More investors are swarming to bigger funds, whether by default or through choice. The question I suggest they ask, though, is whether the driving force behind the fund is performance or asset accumulation?

Clearly, performance is paramount and for that we favour, managers with an unconstrained, high-conviction approach; something not generally associated with ‘blockbuster’ funds.

Phil Milburn, manager, Kames High Yield Bond fund

Illiquidity can become a risk

Growing assets under management enables you to afford a bigger team which generates more ideas, but there is a tipping point where illiquidity prevents the execution of ideas. It is hard to outperform the market when you are the market.

We have been vocal on the subject of liquidity, and there is no doubting we would regard some funds as too big for the markets in which they operate.

Clearly seeing PIMCO’s Total Return fund have a dramatic fall in assets is helping to focus market attention to this. Managers need to be honest with their investors and manage funds with strategy and liquidity in mind.

Liquidity is at the heart of our process and that directly drives the fund managers’ decision as to what to buy; never enter a position without an exit strategy.

Mitch Reznick, co-head, Hermes credit, Hermes Fund Managers

Performance is at risk

The increased size of the buy side versus the sell side since the recession of 2008 has substantially undermined trading liquidity.  

It has also made it very difficult for funds of scale to invest with conviction. And while there is little systemic default risk in markets today, the increase in idiosyncratic risk is magnified by this lack of liquidity: credits subject to negative credit events move wide with velocity.

As a result, it is difficult for funds of scale to manage portfolios with conviction predicated on changes to views on specific credit risk and valuations.

Consequently, pockets of the market have become, essentially, ‘buy and can’t sell’. This, then, puts performance at risk. The best way around this is to avoid the crowded trades in the market by investing with a flexible mandate that allows a manager to exploit valuation anomalies across geographies, capital structures.

Jason Broomer, head of investment, Square Mile Investment Consulting & Research

Compromise between AUM and liquidity

Ultimately there is always a compromise between the size of AUM and liquidity. It is important to focus not only on the fund size, but also the total weight of assets that a manager is running in the strategy. 

Clearly, large AUM diminishes the opportunity set available to any manager.

However, to position [something like] £3bn as a threshold seems unhelpful – £3bn is easily manageable for large-cap US equity strategies, for instance. 

Measuring liquidity in markets has been made difficult by the development of off-exchange ‘dark pool’ trading, and determining actual trading volumes is problematic.

We find the old rule of thumb of AUM capacity matching the market cap of the median stock remains a useful approximation for equity funds. 

The problem with liquidity is it is usually available right until the moment you require it.

Markuz Jaffe, research assistant, Financial Express

Large funds have extra resources

The effect of assets under management on performance must be taken on a case-by-case basis. Large funds will benefit immensely from the scale, for example, when new IPOs or bond issues come to market, the larger fund managers will be amongst the first contacted by the investment banks.

This increases their opportunity set within the market when compared to a smaller boutique firm, which sits near the bottom of the pecking order. Additionally, the larger funds will have improved access to corporate management, and be able to dedicate extra resource with the higher revenue stream.

Liquidity is an obvious counter-argument. However, if a significant market event means ‘blockbuster’ funds are shedding assets at fire sale prices, then surely the smaller fund will suffer equally as prices plunge.

Unless there is a clear argument for the fund being too big, it seems logical to reap the upside benefits of a large fund if the losses are going to be mostly unavoidable anyway.

Delyth Richards, head of funds research, Kleinwort Benson

Philosophy, not fund size, matters

Mark Twain put it best when he said ‘it is not the size of the dog in the fight, it is the size of the fight in the dog’.

Despite an increasing amount of research and opinion suggesting fund performance deteriorates as size grows, we are not in the camp to point fingers and run when a fund reaches a certain size.

The scalability of the investment process, something we establish in our on boarding and ongoing reviews, is key in these situations. Following rapid inflows (or outflows) we revisit the strategy and process of funds affected; only if it is compromised is action taken.

There is value in all sizes from niche market specific funds right up to the likes of Standard Life GARS. For us, it is not the size of the fund that will impact returns, but the philosophy that sits around it.

Michael Eyre, fund analyst, Morningstar

Capacity management issues

The trade-off between fund size and performance varies according to a fund’s asset class and management style.

Funds with a more top-down, macro-driven investment process – for example, UK gilt funds are often able to continue generating alpha in larger funds as their opportunity set is not significantly reduced by fund size.

However, funds with a more bottom-up investment process – such as sterling high yield funds – can struggle to continue generating alpha in large funds, as the opportunity set reduces with less liquid securities unable to be sourced in meaningful enough sizes to make an impact on performance.

For this reason, capacity management is a very important consideration when assessing bottom-up driven funds, and is particularly relevant when considering fixed income funds in today’s less liquid environment.

If investors head for the exit doors en masse in fixed income markets, large funds will have a harder time meeting redemptions than smaller funds, and performance may take a knock.

Ben Yearsley, head of investment research, Charles Stanley Direct

Difficult to turn money away

Clearly, fund groups with large funds will say there is no impact, whereas groups with many small funds, often boutiques, will highlight how nimble and reactive to market conditions they are.

It is obvious that running a smaller fund will be easier than a larger one.
Managers should be able to get in and out of positions quicker, and possibly at a better price.

However, that does not mean you should ignore large funds, as these are often run by managers who have consistently outperformed over the long term.

One thing that does frustrate me is when a fund group launches a fund and states that manager X only wants to manage a certain amount; lo and behold as soon as the fund nears that target size, miraculously the target is now increased to a much larger level. Either a fund (and strategy) is capacity constrained or it is not.

It is very difficult for sales and marketing directors to turn money away.