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James Klempster, CFA | 11 May 2020

Size Matters

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There’s no two ways about it: size matters. We live in a society that admires big - The Angel of the North, the Great Wall - yet we also revere the precision of small - the microprocessor, automatic watches. When it comes to disadvantages, both large and small also can be found wanting. Needless to say, in the world of fund management things are equally nuanced. Plenty of academic literature has been devoted to whether fund manager scale is an explanatory factor for outperformance. Rather than rake over those nebulous arguments again here, the purpose of this article is to discuss why capacity management is – from a very practical perspective – absolutely essential if fund managers want to have a decent chance of delivering on their chosen investor outcomes.

First, let’s focus on the conflict that is present, to a greater or lesser degree, in every fund management firm. There are three ways most fund managers are able to improve their profitability, namely managing costs, pushing up ad valorem fees or having a greater pot of money on which to charge a fee. Of the three, our cost base is the part of our business model over which we have the most control. Increasing total expense ratios would be perceived as swimming against the tide in most instances and so, for most fund management firms, the surest route to being more profitable is to increase assets under management without a proportionate increase in costs.

That is fair enough but as potential investors with these businesses we need to assess assets under management (AUM) with a level of judiciousness that would make Goldilocks proud: not too big, not too small, but just right. This applies not only at a firm level but at a strategy level too. Unfortunately there is no single answer to this conundrum, each potential investment needs to be judged on its merits based on the asset class, the fund manager’s style, the research requirements and, crucially, the capacity for them in the markets in which they operate.

Some funds are just too small. There are a number of issues that this can cause for example, funds hitting minimum fixed fee levels with service providers, such as administrators, which push up TERs; also if a fund is too small to deal in appropriate ticket sizes, they will struggle to trade effectively. Another example is the commercial reality of small funds being unlikely to move the dial in terms of a firm’s revenue line which means it is either a cost drain for a large firm or serious headache for a smaller one.

Most discussions on capacity focus on the opposite problem; that of being too big. The old adage of super tankers being difficult to steer is true and also applies to fund management but, again, its validity depends on the type of investment you are contemplating. Some gargantuan funds have no issues with liquidity because their chosen markets are so deep and utterly liquid. When assessing this risk, one must look at a manager’s AUM and compare it to the market in question. It is also instructive to look at the proportion of a company’s securities that they own; large shareholdings are harder to sell, especially when the going gets tough. It is also worth looking back through a manager’s past to see whether their portfolios – and results – of yesteryear could be replicated with today’s AUM or whether success in asset growth comes at the cost of nimbleness and potential alpha.

Generally speaking, we are most comfortable with firms that have a clearly stated policy on closing their fund due to asset growth and as they grow we continue to assess the appropriateness of this figure. Firms that do the right thing and close a fund to subscriptions while their size remains in a sweet spot are to be commended. Curtailing asset growth means the pool the manager has to use remains fit for purpose and can be deployed effectively to benefit existing investors first and foremost. These firms take the view that investment houses prosper in the long run thanks to performance so they prioritise having assets that are ‘just right’ for their market.

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