Size definitely affects active management risks and returns, writes Matthew Craig. But the relationship is by no means a simple one
When it comes to investment, big is not always beautiful. The performance of an actively managed fund can dip if becomes too big - but, then again, performance can decline for a variety of reasons and fixing the maximum optimal size for a fund can be tricky.
However, there is now a greater awareness of this issue and it is being discussed more frequently. A recent investment viewpoint paper from T Rowe Price, ‘Capacity Management: A Complex, Ongoing Process’, looked at some recent academic research on the topic, while others have found evidence for outperformance by new hedge funds, which tend to be smaller in size.
Moreover, fund managers are arguably more willing to broach the subject, in order to safeguard performance. For example, UK boutique fund manager JO Hambro Capital Management said recently that it would soft close its UK equity income fund once it reached £750m (€892m), in order to maintain its performance. Clive Beagles, a co-manager of the fund, commented: “Running a multi-billion pound fund can make it harder to exploit investment opportunities and preserve outperformance for existing clients.”
Investment consultants say capacity is an issue they take into account when assessing managers. “We have all experienced fund managers growing rapidly, getting big and performance going downhill,” says Mercer’s head of global manager research Andy Barber. “People move around the fund management industry and you do hear comments such as: ‘It was impossible to manage the funds at X, we just had too much money’.”
It is easy to see how this situation could arise. Many fund management firms are asset gatherers, as their revenues increase directly in line with funds under management. As a result, they face a potential conflict between keeping a fund at the optimum size for performance and maximising revenues.
“I cannot recall an investment manager closing a product to new investors and saying ‘we closed too early’,” notes Barber ruefully. Bfinance managing director and head of research and development, Olivier Cassin, says looking at capacity is an important part of the process of assessing a manager. “We try to set up limits and if funds exceed that, we will score it negatively,” he comments. “We start to penalise the fund mildly, and then more aggressively.”
If a fund grows too large, a manager could struggle to keep on top of all the individual holdings, or might not be able to liquidate positions quickly. A fund manager’s investment approach can also change as assets multiply. Lisa Fridman, head of European research at fund of hedge fund manager PAAMCO, says that a tendency to follow market momentum can be introduced in the hedge fund world as more analysts are hired and the founders step back from day-to-day investment analysis.
“Analysts may not be confident in their ideas unless they see price confirmation in the markets, or the portfolio manager may wait for price confirmation because they don’t have the same trust in an analyst’s ability as in their own ideas,” she suggests. Key Asset Management CIO Chris Jones adds that as hedge funds grow they can start to rely more on beta, or market returns. “Because the manager can’t squeeze out any more alpha, they start taking beta or directional risk.”
Another problem when investment managers’ remuneration is linked to fund size can be a loss of manager ‘hunger’ as AUM multiplies. The popular wisdom is that performance fees incentivise managers to maintain performance rather than gather assets, but Jones notes that, if managers are living very well on the fixed management fee alone, they will not want to take too much risk. Cassin agrees: “A Dutch university did some research and found hedge funds are incentivised to perform up to a certain level, but above a certain point the fixed fee becomes a very substantial part of manager income,” he says. “As a result, regardless of performance, the managers are very comfortable.”
As well as these effects, diseconomies of scale are expected to arise when funds increase in size and transaction costs increase. With larger transactions, direct trading expenses might be small compared with the negative price impact of a large buy or sell order.
Transition managers use the concept of implementation shortfall to measure the cost of transitioning a portfolio. This consists of the immediate market impact of the trades, the delay costs of spreading the trades over several days and missed trade opportunity costs. In particular, as transactions become larger, they typically become more expensive because of the price movements they cause, especially in less liquid markets. T Rowe Price’s ‘Capacity Management: A Complex, Ongoing Process’, states: “These price movements may reduce, or even eliminate, the expected returns on an otherwise profitable idea.”
If it is accepted that active manager performance can suffer when assets under management increase beyond a certain size, determining that point generally needs to be done case by case with reference to asset class, investment style and other factors. Cassin says generalising about when capacity becomes an issue is impossible, but added that in emerging markets and frontier markets, with less liquidity and lower market capitalisation, it would become a concern sooner than in global equities or developed markets.
For hedge funds, the same is true. “The optimum level really varies from strategy to strategy,” says Jones. “In niche areas, £1bn could be too big. We have seen a number of hedge funds re-invent themselves post 2008 as they have decreased in size. They have become more transparent, more nimble, more driven.”
In terms of liquidity and size, Barber said he would start to worry if a fund manager owned much more than 1% of a market. “I would worry long before that for someone who has high turnover or a permanent bias away from large-cap stocks,” he adds. “Looking at measures such as how long it would take to trade a portfolio back to benchmark or cash can be useful in assessing capacity limits.”
Some managers running concentrated portfolios say that they are capacity constrained simply because they do not want to own too big a portion of any one company, but Bfinance’s Cassin actually does not see the number of stocks held as a critical factor regarding capacity. “The common wisdom is that in concentrated portfolios, size matters more because the fund will be trading large blocks of shares but, having said that, I don’t think there is any rule,” he says. “A manager might only hold 40 stocks, but if it is a contrarian, large-cap manager with a low turnover, capacity might not be an issue.”
However, a manager holding 100 mid-cap European stocks and seeking plenty of alpha might find capacity becoming an issue fairly quickly. A fund’s capacity can also be affected by its client base. “A manager with a retail, fund of funds or asset allocator client base may have more inflows or outflows than a manager with a purely institutional client base,” Cassin expains.
While capacity can become an issue for managers, it should be pointed out that a lack of assets can be a bigger problem. Operational risk might be a concern at smaller fund managers. “If a manager can’t afford to pay for good infrastructure and a good research team, that can be as dangerous as being too big,” as Jones puts it. He added that without fixed fee income to cover fixed costs, a manager might take excessive risks in order to win performance fees.
It is clear that size does matter when it comes to fund manager performance, but as T Rowe Price concluded in its report: “The link between portfolio size and performance is neither simple nor static, making both current and expected capacity extremely difficult to estimate with precision.”
Nevertheless, it is an issue to consider when selecting and reviewing active managers.