Too big to be a winner?

The Woodford scenario

Neil Woodford, arguably the UK's most renowned fund manager, currently manages £8.7bn in his Invesco Perpetual Income fund and £11bn in his Invesco Perpetual High Income fund. If either fund were a standalone fund management company they would be among the 20 largest in the UK.

But analysts warn that if a fund gets too big it is impossible for a manager to have a nimble investment approach or invest meaningfully in less liquid issues. It also means that Mr Woodford has substantial stakes in certain companies lower down the cap scale.

Despite these concerns, Mr Woodford's funds boast an impressive long-term record (they did suffer a bout of underperformance in 2009 and 2010 but this was largely due to his defensive investment approach) and are regularly recommended by financial advisers as good income buys.

So what then is the problem with such a behemoth of a fund? "Once a fund becomes too big, it can be challenging for the manager to allocate assets as they wish, without moving markets through their trades or taking positions that are too large in individual companies," explains Martin Bamford of Surrey-based IFA Informed Choice.

This problem became evident in the High Yield and Strategic Bond Fund sectors in late 2008 and again this summer when the market could not absorb the volume of sell orders (ie, there were no buyers in size) so managers could not unload positions they may have wished to sell.

Mr Bamford thinks Neil Woodford has too much money under management. "He no doubt has a strong team behind him and the ability to take up strategic holdings in funds, but we worry with any mandate so large that the manager will lose his or her ability to be nimble."

Acutely aware of size issues, Invesco Perpetual argues that Mr Woodford's investment approach is suited to managing such a large pool of assets given his contrarian and value-orientated approach. He also invests for the long term, gradually building positions rather than timing short-term market movements or jumping on trading opportunities.

"The size of the two funds is something we think about a lot and get asked about frequently," says William Deer, Mr Woodford's product director. "But we don't think that there is a problem. Of course, that's not to say there won't ever be an issue. It is Neil's call if he feels the assets have got too big."

He adds that Mr Woodford has substantial personal assets invested in the funds and all Invesco's fund managers are partly remunerated on performance, in addition to a basic salary.

Invesco also actively analyses Mr Woodford's requirements for liquidity relative to the available pool of liquidity – taking average turnover and applying that number to an ever-increasing pool of assets. The assets of all his mandates in 1995 were £650m, compared with £22bn by December 2010. Despite this near 34-fold increase, his impact on the market is virtually the same. "The UK stock market remains highly liquid and, while our assets have grown, at the same time market liquidity and turnover has increased," explains Mr Deer.

But what about the risks involved with having large stakes in single companies – Mr Woodford has holdings of almost 30 per cent in companies such as Omega Insurance and Drax. "Clearly it is not without its risks and it does tend to be in the small and mid-caps where we have such large investments. But to put it in perspective – we might own 29 per cent of a company but this might represent just 7 basis points in the fund," explains Mr Deer.

He adds that there are benefits to being such a large investor – "we are able to ensure that our interests and the interests of our clients are in line with the management of the companies we are investing in. You can influence the strategic direction of the business, the make-up of the board, any acquisitions, dividend pay-out ratios – these are real positives that are not often reflected."

The case for soft closure

While a number of asset managers boast funds with well over a billion pounds in assets (see table below of the 10 largest IMA funds), there are asset managers who instead choose to soft-close funds to stop them getting to a size that impacts the manager's ability to generate returns. Soft closure is a means of dissuading clients from investing new money into a fund by making the initial charge compulsory (as opposed to hard closure where the fund does not accept any new money). Regular savers, who maintain the level of their existing contributions, are not affected by soft closure.

The ten largest IMA classified funds

Source: Morningstar

Notes: Performance to 18 November 2011, based on a bid-to-bid basis

There are various examples of funds 'soft closing', including small-cap champion Harry Nimmo's open-ended £1.1bn Standard Life UK Smaller Companies Fund, the £750m JO Hambro Equity Income Fund and the popular Troy Trojan Fund, which had amassed around £1bn in assets.

First State Investments also announced in September this year that, following significant fund inflows, it had decided to soft-close a number of specialist strategies in order to protect the interests of existing investors.

Stuart Paul, joint managing partner of First State's Asia Pacific GEM team in Edinburgh, says: "The criticism of fund managers that grow funds is that they are not completely transparent in terms of how the underlying holdings of those funds are changing over time and that there is a degree of caveat emptor to say it is for the investor to decide how big the fund should get and how the manager runs the fund.

"We have tried to be very explicit about the size of company that can be bought by certain funds. We have 'all cap' funds that invest across the spectrum, 'leaders' funds that do not buy small companies and tend to focus on the mid-cap area, and then 'select' portfolios, which invest in large-caps.”

First State says inflows into its specialist Asia Pacific and Global Emerging Market (GEM) funds have grown rapidly in recent years, with these funds nearing the point beyond which capacity issues could start affecting performance – and, more specifically, restrict their ability to invest in smaller companies. As such, the following funds will be soft-closed from 1 January 2012: First State Asia Pacific Sustainability, First State Indian Subcontinent, First State Global Emerging Markets Sustainability, First State Latin America and First State Greater China Growth. All of these funds invest in large, mid-cap and small companies.

Eight years ago, the First State Asia Pacific and the First State Global Emerging Markets funds were soft-closed. At that time, the First State Asia Pacific Leaders and First State Global Emerging Markets Leaders funds were launched which, in contrast to the two original funds, do not invest in smaller companies. The two Leaders funds therefore remain unaffected by the latest move.

Mr Paul adds that it is important for the manager to be transparent about where the fund is investing and how much the fund holds in a given company. "We closely monitor how much of a company we own and how much of the free float of that company we own. We also look very closely at the market activity in company shares – clearly one does not want to be in a position of moving prices. It is really all three of these things – the absolute ownership, the ownership of the free float and how easily one can buy and sell shares if needed in the marketplace, " he says.

"In the world we operate in, which is different to Neil Woodford's, namely Asia and the emerging markets, there are a lot of big companies that we think are fundamentally flawed – for example by being heavily state-influenced or not run for the benefit of minority shareholders. These are companies that we don't want to own, although many emerging market managers are quite happy to own these."

Small is risky too

While a large fund can be risky, too small a fund can be equally detrimental. Very small funds incur higher charges as fixed costs weigh heavily on them, which in turn can impact performance. If there are a number of redemptions in a small fund and the underlying holdings are illiquid then the manager will be forced to 'dump' stock in the market at a poor price, thus harming the unit price of the fund for investors

All of these size issues within the open-ended fund sector are a point in favour of using investment trusts, where the fund structure mitigates the problem of liquidity. As investment trust prices are determined by the stock market, investment trust managers do not need to sell underlying holdings in order to meet redemptions – a characteristic that can be particularly helpful in times of higher volatility such as the current market conditions.

"Different fund structures will have different optimal sizes, as will their trading activities and underlying types of asset," adds Mr Williams.

Property, for example, can be a particular tricky asset class as was witnessed during 2008 when many open-ended funds were forced to close funds to investor redemptions (property investment trusts didn't suffer from this problem). Some managers of open-ended property funds have also complained of 'bullying' – in that they told bosses in the run-up to the property downturn that they should be scaling back exposure, but instead were told to keep on buying property and encourage investors to pile in and grow fund sizes.

Some might claim that size doesn't matter but in truth it is an important part of the complex web of fund management and how it is handled can be a very significant factor in determining what returns you get.