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Size Matters

Date: 10 November 2021

When it comes to fund size, finding that ‘Goldilocks’ fund, neither too big nor too small, is something often on the minds of fund selectors. Today we talk about the signs that a fund has grown too big and what to do about it.

A couple of weeks ago I spoke on a panel at the Fund Forum event on the topic of M&A within asset management and the impact we see at the fund level. It was a useful reminder that whilst we are certain to see more ongoing M&A, the impact at the fund level can be potentially negative when the largest asset managers continue to gather and aggregate assets. So, what rules should we set ourselves when considering fund sizes and when does a fund become too big?

Firstly, why should we care and what should we specifically care about? The argument goes that as a fund grows, the limitations of market liquidity will erode a manager’s ability to transact in the market and limit their universe. Depending on where the manager’s sweet spot is, that limitation may ultimately reduce their future ability to deliver outperformance at the same level or indeed at all. It is well documented that some of the best performing funds have produced better returns when at smaller AUM sizes in the earlier days of their life than when they have had significant inflow. In other words, most investors never achieve the level of returns that they presumably bought the fund for. That really describes one of the biggest investment issues faced by fund buyers; the perennial temptation to buy the outperforming fund and sell the laggard. The one exception to the rule that bigger isn’t better is possibly the activist, where holding a larger stake in a company may allow greater influence to achieve their objectives, although clearly even these strategies can grow only so big before they are also impacted.

I’ve spoken about the fund size so far, but that is only half the story. If we are considering nimbleness in the market, it is critical to consider strategy size for anything which is mirroring the fund. If the manager has decided it’s time to buy or exit a position, it’s likely to happen across all mirrored funds and strategies. It is very noticeable in the financial press that comments around fund sizes often miss the bigger picture. Take a very often quoted example, Fundsmith. Most comment on the size of the onshore fund, which is around £28bn today. However, the mirrored offshore fund is no minor amount, adding a further £7bn. Extend this example and include any mirrored segregated mandates for the manager you are interested in and the strategy assets become the important number to focus upon. This is particularly the case with some very large US based managers, where the European UCITS is likely to be a tiny proportion of total assets managed in the strategy. As is often the case, individual investors are at an immediate disadvantage given this information isn’t generally freely available, especially if it relates to assets in the US or segregated mandates. As you might expect, it is It is something we pay close attention to and ask of all our managers on a quarterly basis.

So how big is too big? Clearly every fund is unique, but there are a few examples that give a sense of levels. For UK small caps, £1bn is often cited as a good guide to capacity. The more the manager fishes in true small caps rather than mid-caps, the lower that number might become. Even more extreme, the River & Mercantile UK Micro Cap investment trust hands back investors’ money when it grows too far above £100m, as the manager views that as too much when investing in the very smallest part of the market. At the other end of the extreme, we have US large caps. There are numerous managers running tens of billions in assets in that space, and that is perfectly reasonable given the size of companies available to them. Bear in mind the average S&P 500 company is around £60bn, and even the 20 smallest companies have an average market cap of around £5bn, not too far below the level needed to enter the FTSE 100.

It’s worth highlighting at this point that whilst we have some large funds in Europe, they pale in comparison to many in the US. This includes several active funds with over $100bn in assets, which one can’t help but wonder whether they might have achieved better outcomes had their assets been limited.

So how big is too big? Clearly every fund is unique, but there are a few examples that give a sense of levels.

That all said, every manager is different, so how do we assess ‘how big is too big’? Here is my take on it. Firstly, knowing what the manager sees as their capacity early on is always a great starting point. Plenty of fund managers will run their funds as if they are running several billion even if they are only running £100m so that they don’t have to change process over time and have people like me accusing them of style drift. Armed with that capacity number, it is a useful tool if they get nearer their figure. Do they then increase it? The pressure from the sales team can often get to the best managers, and that is an obvious flag. The other obvious flag, and easier to spot for even those that don’t meet the manager, is a drift in how the fund is being managed. Here it can be as basic as an increase in the number of holdings, so that the manager can buy smaller amounts in each company, or an increase in the average size of company relative to the index, which may be reported in some factsheets. We might also add an expansion of the universe, for example to include a small proportion of global companies within a UK fund, although this may not always be due to growing assets. For those with the tools at their disposal, analysing the liquidity of underlying portfolios based on their total assets managed is perhaps a more scientific way to approach the problem.

In an ideal world, the smaller and nimbler the strategy the better. That said, a fund can certainly be too small, and anything below £50m at least needs to be considered in terms of excessive costs associated with running a smaller fund. That doesn’t mean we should avoid small funds necessarily, but seeding new funds needs to come with some expectation that it will grow to a sufficient size to avoid an ongoing cost headwind.

As an investor, what to do next? As we said at the start, excessive AUM is one of the key determinants of weaker performance, so if you have concluded that it is the case then all else equal it should be time to move on. In most areas of the market, you will find more nimble versions of successful funds. Let’s take the style that has worked best over the last few years, growth equities. In the global space it feels like there is a glut of funds that look and feel like the highly successful Fundsmith or Baillie Gifford offerings. They all come with strong track records, often have similar philosophies, and are much smaller. Of course, how much of that is based on skill and how much the prevailing style is the key to picking a new smaller manager, but that is our job. So, tracking AUM and being cognisant of style drift is key. What is harder for some to determine is how much the fund you own is replicated elsewhere by the manager and the impact that might have.

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