Is there a trade-off between fund size and performance?
October 2017 | Roger Walling
Or, could the question be, do fund managers know their limitations?
Fund managers should closely scrutinise and periodically consider the capacity of their strategies and (model) portfolios. Increasing funds under management (FUM) beyond a certain level can limit the ability of a fund or model portfolio to meet its objectives and deliver performance or alpha.
As a fund manager, we regularly field questions regarding capacity. For large institutions, the issue is often about supply: can they invest millions with an investment manager and achieve a target return without impact from the weight or size of their investment? For all investors however, the question is whether performance can still be maintained and delivered off a larger FUM balance.
The reduction in performance, commonly experienced by fund managers as capacity increases known as ‘alpha decay’, is well documented and supported by academic papers. According to the research, returns taper at a given FUM level for a given strategy.
So, what is a fund manager’s capacity?
I don’t believe there is a single answer. Ralton has determined its capacity based on stocks in its universe that are investible and has ‘back solved’ for a sale or purchase of stocks based on market cap and liquidity. We also consider target returns, typical turnover, investment style, number of stock positions and more. Number and type of clients are also important. As a managed accounts specialist, the intellectual property and liquidity requirements for our investments can be significantly different to managers who operate unit trusts.
Earlier I mentioned fund managers should ‘periodically consider’ the capacity of their strategies. I believe this has even greater importance now with the growth of passive investing. Index funds, ETFs, single-purpose strategies (investing for yield, volatility or commodity exposure) are increasing in popularity. This is reducing liquidity across the market which can impact FUM capacity for active managers. Also, such products may distort markets, with the agnostic strategy of ETFs not necessarily capping positions. Where single strategy products hold significant positions in mid-cap stocks, we are particularly wary.
From our vantage, we ultimately see such distortions as future opportunities.
As featured in The Constant Investor