Room to grow?

A spate of UK funds closing to new investment has generally been seen as good for existing investors. However, there is a lack of evidence that large funds are hampered by their size. So, asks Simon Hildrey, do the best things really come in small packages?

George Luckraft has become the latest in a growing line of managers to close their funds to new investors. This is not unusual among hedge funds and even offshore funds, but it has been rare among UK-domiciled funds.

The capping of funds appears to be good news for existing investors. Some say that a large asset base erodes fund performance. A small fund, it is argued, can easily put all its money into its best ideas but a lack of liquidity forces a large fund to invest in less good ideas. Big funds may also have to take larger positions per stock than is optimal, which makes it more difficult for them to get in and out of stocks.

There is a lack of evidence from academic research, however, that small funds outperform large funds because of their size (see box on page 22). A counter-argument is that there are advantages to larger fund sizes, including more resources and research as well as lower total expense ratios. Supporters of this view point to the likes of Anthony Bolton and Neil Woodford to back their claim.

So who is right? Managers of capped and large funds are certainly passionate in defending their respective positions. Angus Tulloch, manager of the First State Asia Pacific fund, says the important issue is not the size of the fund but the pace of growth of new inflows of money. “It is just as easy to run a 1bn fund as a 100m fund. But it is not easy to go from 100m to 1bn in a very short space of time.

“The issue is the speed at which you can find new companies in which to invest when you have large inflows. It is obviously easier to add new money to existing holdings when you invest in large-caps. But if you focus on small and mid-caps and suddenly receive a lot of money, you may have to adjust the type of companies you invest in.

“One of the reasons we capped the size of the Asia Pacific fund was because we invest across the whole market and did not want to compromise this approach and therefore potential returns. We also wanted to maintain flexibility to go anywhere we found value. We felt we would not have the necessary flexibility above 1bn.”

Another reason to discourage new inflows, says Tulloch, is the limit on the size of positions that he wants to build in individual stocks. “We do not want to own more than 10% of a company and 20% of the free-floating shares. Many Asian companies have limited free floats as families often hold on to as much as 60% of the shareholding.”

Tulloch says he can always find good investment ideas, but there are different levels of conviction. For this reason, he takes sizeable positions. The top 10 stocks generally comprise 30% of the portfolio and the top 20 take up 50%.

Scott McGlashan, manager of JO Hambro Capital Management Japan, says the Dublin fund was capped “to give me the maximum opportunity to outperform. The liquidity in the Japanese market is good but it is not unlimited for me as generally I invest outside the largest 100 companies. If the fund is too big it becomes difficult because you have to start buying larger companies.

“In the mid-1990s I was managing a fund with about 400m in assets. I had around 80 holdings in the portfolio but 15 were effectively fillers. They were good companies and would rise in value if the market went up but they would not really help me outperform.”

McGlashan says the JOHCM Japan fund holds between 50 and 60 stocks. He Gadds that he likes 75% of the portfolio to be liquid within one day and 90% to be liquid within three days. This leaves no more than 10% of the fund in relatively illiquid stocks.

Patrick Evershed, manager of New Star Select Opportunities, has had different stages to capping the size of his fund. When the fund was launched, he closed at 50m. He has subsequently reopened the fund to new money, but it is now at its optimum size of about 170m. While Evershed’s mandate allows him to invest in any size of company, he is conscious about the size of a stock he owns. He will typically hold up to 3% of a company, with 4% being the maximum holding.

The primary issue, says Evershed, is the ability to invest strong inflows. “There is no shortage of new stock ideas, but there is a limit to how quickly new money can be invested. I could not find 100 good stock ideas in three weeks, for example. When we launched I restricted the size of the fund because I did not feel I could find enough stocks I really liked for more than 50m. I have around 160 stocks in the portfolio now but I would not want any more stocks than this.”

Fund of funds manager T Bailey sold its holding in the Schroder UK Mid 250 fund in September 2004 because of concerns about the amount of money that Andy Brough was running. It transferred the 4.4m to Old Mutual UK Select Mid Cap.

“It is important not just to look at the amount of assets in one fund but all the money a fund manager is running,” says Jason Britton, co-fund manager of the T Bailey Growth fund. “If fund managers run various mandates in the same way, this can make their job harder rather than easier. This is because they have to invest in and redeem from stocks across their mandates at the same time.

“We felt Andy Brough was managing too much money across his unit trust and institutional mandates and this was an extra risk we did not need to take. If there are other good managers and funds in the sector with smaller funds, we will tend to opt for the latter. This is not to say managers like Brough will struggle, but that we may not want to take on the extra risk.”

The best example of a successful large fund is Fidelity Special Situations. Anthony Bolton admits he has had to adapt his approach slightly as the size of the fund has grown. “As the fund size has risen I have found it necessary to introduce more holdings and increase my weighting in larger stocks. Two key effects of size are that with more holdings it is essential for me to have the help of the large team of analysts here at Fidelity in monitoring these holdings. It would be near-impossible for me on my own to be on top of all the newsflow in each of the 200 or so holdings I have. Also, I frequently need to be early in my buying and sometimes selling. I have to consider not just what I want to buy, but also the best way to be buying it.”

As well as increasing his positions in larger stocks over time, Bolton says he has chosen not to invest in companies with a market cap of under 100m. “It is true that the bigger the fund, the less manoeuvrable it becomes. However, as a manager I don’t tend to make sudden changes to the portfolio so this does not become a major issue.”

Bolton says there is a limit to which the Special Situations fund can grow in size. “I do believe there is a point, but I’m not sure exactly what it is. However, when giving up the management of Fidelity Funds European Growth at the start of 2003, I reduced my weighting in UK stocks substantially.”

He adds that to manage large funds, managers need plentiful support. “We have 58 pan-European equity sector analysts working out of London and they are the foundation of our work. Much depends on the depth and breadth of our company research. Our main input is in the form of regular meetings with companies. In our London office alone, we see between 15 and 20 companies every day and I meet one or two companies myself every day.”

Nick Hamilton, product director of UK equities at Invesco Perpetual, says a key factor in determining whether a fund has reached capacity is the turnover of shares in its portfolio. “The size of the fund is a different issue if there is a 110% turnover of the portfolio in a year than if there is 20%. The average holding period in the Invesco Perpetual Income fund is three to five years. This is why Neil Woodford has been able to sustain performance while managing such a large fund.

“As Neil and the team have a low turnover of stocks they do not have a heavy footprint in the market. They take a long-term approach to managing money, which supports the running of a large fund. Neil, therefore, has not had to change the investment approach as the fund has grown in size. He finds stocks he likes across the market.

“Liquidity has not been an issue for Neil. As he takes a long-term approach, he tends to buy when other investors are trying to sell and sells companies when others are buying. This means he can always have liquidity in his portfolio. Liquidity is also less of an issue when you take a long-term approach.”

Hamilton admits that if Woodford took a different investment style then capacity would be a more of an issue. He says Woodford has not been prevented from buying any small-caps because of the size of his fund. But he adds: “We do monitor the size of the funds. If we felt they were growing too large so we could not invest properly, we would have to review the situation.”

Two of the factors that assist Woodford are that there are 14 investment professionals in the UK equity team and the fund can invest in non-UK stocks. Currently, he holds about 7% of the portfolio in two overseas stocks – Altria, which owns Philip Morris and Kraft Foods, and RJ Reynolds.

The Schroder UK Mid 250 fund has grown from 30m in November 1999 to more than 1bn. Andy Brough says he is comfortable with this size of fund and attributes this to his investment approach. This is characterised by a low turnover in the portfolio and a relatively long-term holding period.

But crucially, says Brough, he tends to buy shares when they are out of favour. He says liquidity is only a problem if a manager is trying to buy or sell small-caps when many other investors are attempting to do the same.

He argues that the advantage of a large fund is that it gives managers a seat at the table with chief executives of listed companies. “A large fund provides greater access to directors and chief executives. If things go wrong then we can have an influence on the course of action that the company should take. It also gives us access to behind the scenes at companies.”

This is an issue taken up by Tony Nutt, manager of the Jupiter Income fund. “One of the major benefits of a large fund is that it can give you a seat at the table. When things happen at companies, you have a greater insight because of your significant holding. It enables us to talk to management and insist on certain changes being made at the company. As a large shareholder you have a greater voice.”

Nutt says that large funds generally only invest in stocks when they have a high level of confidence in the company. This is partly because it is easier for small funds to redeem from a stock and therefore correct a “mistake”. He adds: “Small funds are more able to jump from stock to stock. If I did not have a high conviction about a company, I would not invest in the first place when managing a large fund.”

On the question of whether managers of successful small funds are able to outperform as funds grow in size, Nutt says: “Not all fund managers can achieve this. Investors should look at where returns are coming from and how much risk is being taken to achieve the returns. If most of the returns have come from only a couple of stocks there is a lower probability that outperformance is sustainable as the fund grows. Returns from a wider number of stocks suggest the approach is repeatable with larger assets.”

Mary Chris Gay, manager of the Dublin-listed Legg Mason Value fund, says one of the crucial factors in ensuring her fund’s performance is its long-term approach to investment. She argues that the fund has a low rate of turnover as it has an average holding period of stocks of five to 10 years. The turnover rate has been 4% a year and in 2004 reached 6.9%.

Furthermore, Gay says the fund does not hold stocks with capitalisation below $10bn-15bn (5.7bn-8.5bn). “Most of our underlying holdings have capitalisations of between $20bn and $30bn. A third of the Value fund is in companies worth more than $50bn. This reduces liquidity issues for the fund in managing large amounts of assets. We could certainly manage two to two-and-a-half times our current assets.”

The academic research is inconclusive on whether the growth in the size of funds impacts on performance. But even managers successfully running large funds admit there is a point at which size will start to affect returns detrimentally.

The maximum size will be determined by the part of the market in which the fund is investing, the investment style and approach of the manager, the skill of the manager and the liquidity in the market. The key is for fund managers to know the limits on their own funds.

How size affects the cost of funds
Jim Roberts, investment director of Skandia, says there are questions that investors need to consider for both small and large funds. The first factor is that expenses are greater for small than large funds. “Total expense ratios are highly correlated with the size of funds. This is due to the benefits of economies of scale. There are certain fixed costs that have to be paid by all funds.” Furthermore, transaction costs have a greater effect on diluting performance among small funds, according to Roberts. This is partly because of the more favourable price that can be achieved by larger funds as they are trading more assets.

He argues that investors should be wary of funds with small amounts of assets because of the increased cost. “A large amount of skill is required to overcome the increased expense. It is like extra weights of cost have been attached to the fund. New funds face a serious issue if they have large inflows because of the high transaction costs. Many multi-managers will defer investing until funds have grown to a reasonable size.”

The other question investors need to consider, says Roberts, is whether managers who have outperformed while running small funds can repeat their success with large funds. He cites Invesco Perpetual European Growth as an example of a fund that grew too large, too quickly. Under the management of Rory Powe, says Roberts, it was one of the top-performing funds by investing in small and mid-cap stocks. But when the fund grew, it had to increase its exposure to large-caps.

Research by Fitzrovia International supports the view that costs are higher for small funds, which could have an impact on performance, but for onshore funds investors may not be receiving the full benefit. Fitzrovia discovered that the differential in costs between large and small funds is much greater among offshore than onshore funds.

Ed Moisson, head of communications at Fitzrovia International, says it grouped all actively managed onshore equity funds by ranges of total net assets. “The analysis provides a picture of increasing fund assets being related to declining charges, even if this picture is not perfectly uniform. Once funds have attracted fund assets of around 25m, however, continued economies of scale are not significant with average total expense ratios (TERs) varying by only four basis points for the four larger ranges of fund assets.”

The average TER fell from 1.69% for funds with assets of less than 10m to 1.43% between 10m and 25m. But average TERs then only decline to 1.30% for funds with assets of more than 200m. In contrast, the average management charge only declines from 1.19% to 1.17% for funds with less than 10m and more than 200m.

Moisson adds: “Taking the TERs and management charges figures together, one might conclude that further significant economies of scale are only likely to occur through reductions in the percentage annual management charge for larger funds.

“Fund management companies might wish to consider the US mechanism of tiered management charges. In this way, economies of scale would be passed on to investors for the core cost of investment management and not just for the fixed non-management charges.”

In stark contrast, the average TERs for Luxembourg-based funds fall from 3.59% for funds smaller than $5m (2.85m) to 1.63% for funds with more than $250m in assets. The average annual management fee also has a steeper decline than in Britain, from 1.34% to 1.24%.

Academic and Lipper research
Andrew Clark, senior research analyst at Lipper, says there is little direct evidence that fund size erodes performance. Using a sample of funds from 1974 to 1984, Grinblatt and Titman1 find some evidence that gross fund returns (constructed only from fund stock holdings) decline with size, but do not find a similar effect using net fund returns.

He adds that other studies, such as by Perold and Solomon2, use simulations to show the size of the asset base can significantly erode performance by assuming that bigger funds have to take larger positions in the same set of stocks and hence suffer more from price impact. Three more recent papers by Lillo et al3, Rosenow4 and Plerou et al5, have shown that the price impact is not as significant as Perold and Solomon assumed.

But recent papers by Chen et al6 and Indro et al7 find that fund performance does affect performance. Using data between 1962 and 1999, Chen et al find that fund performance is negatively correlated with total net assets on a gross, net and risk-adjusted return basis. Indro et al, using a sample from 1993 to 1995, argued that funds larger than their optimal size tend to over-invest in information gathering and trading.

Lipper has studied the performance and size of core, growth and value funds in America between 1999 and 2001. Clark says the research provides no consistent evidence of fund size affecting performance. “Our research shows there is no consistent, statistically significant return difference between large and small funds over a variety of holding periods from 1991 to 2001. For gross returns, while we often find single periods when small funds outperform large, we never find a single contiguous period where this is the case.

“When we do find net and risk-adjusted return outperformance, we find the largest funds outperforming the smallest funds. This is in direct opposition to both the proxy and liquidity hypotheses. Our findings lead us to conclude that for the retail investor, there is probably nothing to be gained by filtering on fund size.”

Lipper then carried out a second research project to analyse whether size affected performance among small-caps and large-cap growth funds in America between 1997 and 2001. Clark says there is evidence of the effect of fund size on performance among the three small-cap classifications of small-cap core, small-cap growth and small-cap value funds.

Clark says: “Only small-cap funds appear to have fund size affecting their performance and we find smaller is indeed better. The effect seems to be due to liquidity issues. However, further research may be needed to be sure it is indeed liquidity issues that are driving the size effect. “While our standard model seems to indicate that fund size does affect performance (bigger is better) among large-cap growth funds, we find two other equally descriptive models where fund size does not affect performance. This leads us to conclude the evidence for fund size affecting performance is not entirely convincing for large-cap growth funds.”

1 Mark Grinblatt and Sheridan Titman, “Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings,” Journal of Business, 1998, Volume 62, pp 393-416

2 Andre Perold and Robert Solomon, “The Right Amount of Assets Under Management,” Financial Analyst Journal, 1991, Volume 47, pp31-39

3 Fabrizio Lillo, J Doyne Farmer, Rosario Mategna, “Single Curve Collapse of the Price Impact Function for the NYSE,” 17 July 2002

4 Bernd Rosenow, “Fluctuations and Market Friction in Financial Trading,” 6 July 2001

5 Vasiliki Plerou, Parameswaran Gospikrishnan, Xavier Gabaix and HE Stanley, “Quantifying Stock Price Response to Demand Fluctuations,” 29 June 2002

6 Joseph Chen, Harrison Hong, Ming Huang and Jeffrey Kubik, “Does Fund Size Affect Performance? Liquidity, Organizational Diseconomies and Active Money Management,” American Economic Review, December 2004, Volume 94, Number 5

7 Daniel Indro, Christine Jiang, Michael Hu and Wayne Lee, “Mutual Fund Performance: Does Fund Size Matter,” Journal of Investing, Summer 1998, Volume 7, Number 2, pp 46-53