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Some funds can maintain their performance as they get bigger while others can’t. In this article, we reveal our tips for finding funds that are the right size for their respective mandate and how to spot a fund that could be getting too big for its boots.
In business, growth equals success, and stagnation or decline spells the opposite. But when it comes to fund management, the growth imperative can sometimes prove destructive – and it has negative effects on clients and investors, which you need to be aware of!
In a world where fee income is mostly determined by the size of a manager’s assets under management (AUM), there is a clear incentive for managers to pursue growth in AUM regardless of the overall impact on fund performance.
This creates the scope for a conflict of interest between the fund manager and the investor and is therefore something both parties should be on the lookout for.
In this article, we’ll explain why some funds can maintain their performance as they get bigger while others can’t. We’ll also reveal our tips for finding funds that are the right size for their respective mandate and how to spot a fund that could be getting too big for its boots.
There are two main ways for a fund to grow its AUM:
positive investment performance
inflows from investors
Aside from these two factors, some funds can also use leverage (debt) to increase their AUM.
Besides growth in fee income, there are some very good reasons why funds often want to grow in size. A bigger fund can spread its operating expenses over a larger asset base, meaning that the fees charged to shareholders can be reduced as a proportion of total assets under management.
Another valid reason for funds to grow in size is that institutions will often only invest when a fund reaches a certain threshold of AUM. This is because institutions need large amounts of exposure in order for it to be worth their while to carry out the due diligence process.
Getting bigger is fine so long as a fund manager is able to deliver on the strategy originally outlined to investors.
For some funds massive growth in AUM needn’t be an issue – for example, an S&P 500 index fund can keep growing quite easily whilst maintaining its original investment mandate of tracking the performance of the S&P. Another good example is a corporate bond fund, as bond markets are deep and highly liquid, which means they can support a very large fund size.
The problem arises when growth in AUM reaches a point that jeopardises the viability of the original investment strategy. A good example of this could be a smaller company fund which started with a relatively small amount of money, enabling it to take relatively concentrated positions in microcap stocks. If AUM went from USD 100 million to USD 1 billion, this could force the manager to expand the range of positions or indeed move up the market capitalisation spectrum. Neither option would stay true to the original mandate.
When fund size impinges upon the manager’s ability to continue to operate the mandate effectively, the manager essentially has three options:
Adjust the investment approach: This could solve the problem in the sense that the fund could operate its new mandate effectively, but it may alienate some existing investors.
Continue to operate the original strategy: For example, a small-cap fund might simply spread its capital across a greater number of positions, but this runs the risk of having less of the portfolio in the manager’s best ideas and therefore impacting performance.
Close the fund to new investors.
No surprises for guessing that most managers struggle to do the right thing, which would be to choose option number 3.
Of course, it’s a perfectly acceptable business decision to decide that expanding AUM at the risk of weaker performance is the way to go. However, what it has done in practice is give the active management industry a bad name through the proliferation of what the industry refers to as “closet trackers”, which is where a fund doesn’t deviate much from the performance of a benchmark or index, but charges fees that are more suitable for a truly active fund manager.
So how do you spot a fund that is the right size for its mandate and could be a strong performer for your portfolio?
Here are a few pointers to help you on your way:
How does the size fit with the strategy? If a small cap fund runs into the billions, are its best days likely to still be ahead of it? Probably not.
Does the manager have skin in the game? If the manager has a significant portion of their own wealth in the product, that’s a good sign that there is confidence in the strategy and the fund’s ability to execute at its current size.
Is there much cash? If there is a significant cash pile it could indicate that the manager doesn’t have enough suitable opportunities to deploy the cash. This could suggest that the fund is too large and warrants further investigation to verify the reason for the large cash pile.
How long has the fund been around? If the fund has existed for several years but still only has AUM in the low tens of millions, it is still probably sub scale and unlikely to have performed well enough to attract investors’ attention.
There are no hard and fast rules as to how big or small a fund should be, but an investor needs to be aware of how size can impact performance. Be sure to ask your fund manager how big they believe their fund can get before it becomes unwieldy. If they don’t stick by their convictions by capping the fund once it reaches that size – then it could be time to get out.
Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.
By James Faulkner
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