Even the best-performing funds can struggle to grow, but when they succeed it spells major benefits for investors. A larger fund has economies of scale that can translate into lower fees for investors. And in an age when investment firms increasingly rely on such economies of scale to make investing commercially viable, a fund with a good level of assets is less likely to get closed or merged into another product.
However, size can also become a problem. If a fund has so many assets that its manager needs to take a large stake in a company to build up a meaningful position, this can create future liquidity problems. If an equity manager wants to significantly reduce exposure in such a scenario it means selling a large amount of shares in the company – something that can push down the price and hurt the fund’s performance.
This problem has been illustrated, in part, by the recent troubles of Woodford Investment Management. LF Woodford Equity Income (GB00BLRZQC88), which suspended dealing in June, has big stakes in many of its holdings, meaning a decision to exit a stock can drag down the share price if executed too fast. Manager Neil Woodford has said he is getting good prices for the holdings he is currently selling.
He is not the only high-profile manager at the centre of size-related concerns. Earlier this year broker Charles Stanley removed Terry Smith’s Fundsmith Equity (GB00B41YBW71) from a list of its preferred names on the back of concerns that the fund “continues to forge into unchartered territory in terms of its size”.
Analyst Rob Morgan warned that big funds can sometimes lose flexibility in terms of what they can buy. In the case of Fundsmith he noted that its roughly £19bn of assets could become “more of a challenge” for the manager.
In the case of Fundsmith Equity, there is a debate to be had about whether it has become too big. It focuses entirely on large and mega-sized companies, allowing it to develop much greater scale than other funds without running into liquidity problems. The fund also has no focus on smaller companies and little need to trade in and out of holdings.
Michael Paul, head of fund research at Brewin Dolphin, says: “We remain comfortable owning Fundsmith Equity, despite the large headline assets under management of the fund. This is a buy-and-hold approach to very large-cap global equities.”
Either way, size can hold back returns if it prevents funds from holding the best investments. The limits of Fundsmith Equity’s large-cap focus are illustrated by the fact that the company has launched an investment trust, Smithson (SSON), with the explicit aim of buying companies too small to include in the flagship fund.
Size is not always a reason to sell, but many funds have now built up substantial scale. There are also several potential warning signs that a fund might have taken on too many assets.
Warning signs
One thing to monitor is the speed at which a fund is growing. If the fund’s assets under management, listed in monthly factsheets, are rising particularly quickly, the manager may struggle to invest such a large amount of new money.
A Morningstar report from November 2018, “Evaluating capacity and liquidity for equity strategies: How to tell when a fund has become too big”, explains: “It’s much harder to put large sudden inflows of capital to work than it would be if those flows were spaced out over a longer period.
“Funds that show big monthly inflows may well have performance diluted in a rising market until that money can be put to work. Managers may opt to hold more cash, tempering performance in an up market.”
A rapid increase in the number of holdings in a fund – something also listed in factsheets – can be equally telling.
“As the fund grows in size liquidity becomes more of an issue, so they’re likely to need to increase the number of holdings in the fund – reducing the concentration in their best ideas and increasing the risk of having a long tail of holdings that are unresearched,” notes Andrew Gilbert, senior investment manager at Parmenion.
“As a result of the increased number of holdings, they typically require an ever increasing team size, including additional co-managers in some cases. This affects the team dynamics and can have unintended effects in terms of idea creation, portfolio management, productivity and risk control.”
Managing too much money can be a problem for funds for various reasons. A manager running a bloated fund might struggle to find enough good ideas or risk future liquidity challenges. And as Morningstar’s report notes, it can also force managers beyond their area of specialism.
For example, a small-cap expert with too many assets might look to house money in the mid-cap space, an area they are less knowledgeable about.
This, again, can show up in the form of various metrics. In the equity space, some factsheets detail the size of company a fund is investing in, either in terms of its exposure to different size bands or the average market capitalisation of its holdings. If there are signs of a fund suddenly buying much bigger companies, this could indicate they are managing too many assets.
Other possible warning signs are less easy to monitor but can be useful. For example, Mr Paul notes that a big change in how often the manager changes their portfolio can be a sign of trouble.
“Is the turnover of the fund changing drastically? This will not be applicable to all funds, but for those that have traditionally been very actively managed, a fall in turnover might indicate the manager is no longer able to implement their strategy due to size,” explains Mr Paul.
Similarly a big change in a fund’s active share – the measure of how widely it differs from its benchmark index in terms of what it holds – can be one indicator of excess assets. Some investment managers have started to list their funds’ active share measures in recent years.
“A rise in active share... could mean that a small-cap fund with a small-cap benchmark has had to start buying mid-caps to deal with inflows,” Morningstar’s report explains. “A drop in active share, on the other hand, may be an indication that a fund has had to move closer to its benchmark, perhaps by buying more of the larger-cap names in the index, to cope with inflows.”
Capacity in context
While big shifts in the metrics listed above can suggest a manager is facing capacity issues, there is no detail that guarantees there are problems. A fund's capacity, or ability to run greater assets, can also fluctuate because it is often heavily dependent on how liquid the underlying market is.
The shares of bigger companies tend to be highly liquid, allowing managers to control greater sums of money. Funds focusing on big companies, such as global or US large-cap names, are less likely to run into liquidity issues than some of their peers.
Liquidity does become a problem in areas with less trading, however. Smaller companies funds have to contend with lower liquidity, meaning they have less scope to take on assets. This can also apply to areas such as corporate bonds and emerging markets.
The average size of a fund in a certain area can give a rough indication of the size, and liquidity, of the underlying market. As the table below notes, a fund in the Investment Association North America sector will tend to be bigger than an IA UK All Companies fund, reflecting the differing sizes of the markets involved.
Bond funds have been the focus of some concern. When asked to list funds which now look too large, investors mentioned two funds run by M&G’s well-respected bond team. M&G Optimal Income (GB00B1H05601) had around £3.5bn in assets at the end of July, with much more money in its Sicav version, available to European investors. M&G Corporate Bond (GB0031285900) also had around £3.5bn.
The size of another fixed income fund, Fidelity MoneyBuilder Income (GB00B3Z9PT62), has been cited as a cause for concern. This corporate bond fund had more than £3bn in assets at the end of July.
All three of these funds have exposure to corporate bonds, which have long been a focus of liquidity concerns for investors. However, both M&G and Fidelity International dismissed such concerns.
An M&G spokesman said Optimal Income was highly diversified by geography, asset class and holdings, with many positions and the flexibility to invest in equities. They added that M&G Corporate Bond could also diversify into other markets.
Fidelity MoneyBuilder Income lead manager Sajiv Vaid said the fund was more diversified in recognition of how market liquidity had changed since the financial crash, and that the fund had “maintained discipline” in terms of its investment style. He added that in terms of liquidity, high-quality corporate bonds were very different from the assets “some notable funds making the headlines recently have been invested in”.
The concerns are not restricted to bond names. Hermes Global Emerging Markets (IE00B3DJ5K90), a popular fund run by Gary Greenberg, was also mentioned. The fund focuses on larger companies but has around £4bn in assets, spread across just 51 holdings. Hermes said that it regularly reviewed capacity in all its funds, with rigorous corporate governance procedures in place to ensure that capacity and its impact continue to be monitored.
Size is not always a problem for investors. Some, for example, note that Aberdeen Standard Investments Global Absolute Return Strategies (GB00B7K3T226) managed to take on substantial assets, but not all specialists view this as a concern in itself. Matthew Hoggarth, head of research at Thesis, notes: “It was able to grow to around £26bn because most of its positions are implemented using derivatives and liquidity is not a problem.”
Others go on to list fund managers who have taken on assets but appear to be running the money well, without capacity challenges. Chris Metcalfe, of IBOSS Asset Management, is a fan of Fidelity Asia (GB00B6Y7NF43), which has more than £3bn in assets after years of strong performance. Manager Teera Chanpongsang looks for companies that trade below their intrinsic value, including restructuring and turnaround cases.
"This is a large- and mega-cap growth-orientated fund and as such it should be able to continue to grow its assets with no detriment to its strong performance," Mr Metcalfe explains.
Large-cap equity investing is not the only area where funds can run big sums of money. Direct property investment is one area associated with illiquidity given the difficulty of selling buildings quickly. But as the table shows, property funds can often control significant amounts of money because the assets they invest in often sell for large sums.
“Sometimes size can be an advantage. At £3.3bn, L&G UK Property (GB00BK35F390) can invest in properties costing £100m and still remain diversified,” says Mr Hoggarth.
Finally, while greater size has its implications in the passive space, investors need not worry about this when it comes to the likes of trackers.
"In passive vehicles where size begets efficiency and lower overall cost, it’s generally the bigger the better when it comes to how large the fund and fund manager is," says Nic Spicer, UK head of research at PortfolioMetrix.