Next best funds: how you can mitigate manager and size risk

It’s reassuring to know that your money is invested in a fund run by a manager with a good reputation, which has reliably and consistently delivered good returns over the years. The problem is, such funds can grow to a considerable size due to their strong returns and inflows of money. This can mean that a fund is not able to invest as much in the area and via the strategy that have helped to generate its strong returns, so in the years ahead its performance might not be as good.

And while it is good if the fund's manager is experienced, this also tends to mean that they are mature so may not continue to run it for very much longer.

You don't necessarily want to sell such funds because they are likely to continue doing well in the near term and maybe longer. This is because it is not a given that such factors will detract from performance. So a good solution can be to hedge your bets: keep your existing holding but invest new money that you would have put into this fund in a similar one. This will allow you to benefit from your existing fund while also mitigating size and manager risk.

Below are examples of successful funds alongside which you could consider holding a “next best”. This is, of course, as long as it doesn’t mean that you end up holding too many funds in your portfolio. Advisers suggest that at most you should have around 15 to 20 – and this is if you have a very large portfolio. So only add another fund covering the same area if you have a sizeable investment portfolio. Also see How many portfolio holdings should you have (IC, 19 June 2020)

Fundsmith Equity (GB00B41YBW71)

Fundsmith Equity is a classic example of a successful fund run by a talented and high-profile manager which has become very large. As of the end of February, the fund’s assets had grown to £22.6bn and while Terry Smith continues as lead manager, he is in his late 60s and has recently made reference to succession plans (see Life after Terry Smith, IC 5 March 2021).

When he does retire, his likely successors are people who have worked with him for years and know the fund and its strategy well. But there's no guarantee that they will be able to replicate his success and, in the immediate aftermath of Smith’s eventual retirement, some investors may withdraw their money from the fund. This should be manageable as the fund invests in some of the world’s largest and most easily tradeable companies, but handling this could be a distraction and have an effect at least on short-term returns (see Is Fundsmith's size detrimental? IC, 6 November 2020).

So if you have a large holding in this fund you could consider putting new money intended for it into a ‘next best’. One such fund might be LF Blue Whale Growth (GB00BD6PG563). Like Fundsmith Equity, this global equities fund is concentrated, with just 30 holdings at the end of February. It also tends to invest in large, high-quality global multi-nationals and around 70 per cent of its assets are listed in the US. Since its launch in 2017 performance has been good and – crucially – it had assets of £680m at the end of February, so it's much smaller and arguably nimbler than Fundsmith Equity.

Stephen Yiu, lead manager of the fund and co-founder of Blue Whale Capital, the company that runs it, is in his 40s. He asserts that: “Investors can rest assured I will be here for the long term! And with an average age in the team of just 35, we believe we have many years together running LF Blue Whale Growth.”

But there are some key differences that mean LF Blue Whale Growth could deliver a very different return profile to Fundsmith Equity. For example, 58.5 per cent of its assets were in tech companies at the end of February, a very punchy bet for what is meant to be a broad fund which could make it more volatile than Fundsmith Equity. Only about 14 per cent of its assets were in consumer companies, which accounted for about 38 per cent of Fundsmith Equity’s assets at the end of February.

Jason Hollands, managing director at Tilney, highlights Loomis Sayles Global Growth Equity (LU2045821571) as another option. This launched in 2016 and had assets worth $776.82m (£566.22m) at the end of February. “Like Fundsmith Equity, it takes a bottom-up approach and [is] concentrated," he says. "[The holdings are] large-cap, growth businesses with wide “economic moat” characteristics – strong barriers to competition and free cash flow, and a high return on equity.”

Loomis Sayles Global Equity Growth's manager, Aziz Hamzaogullari, uses a seven-step research approach to identify high-quality businesses with sustainable competitive advantages and profitable growth that are trading at a significant discount to their intrinsic value. He likes businesses where growth drivers are likely to be intact at least five years from now. And he aims to keep holdings for the long term because he believes that investing in businesses as partners, rather than simply trading stocks, is a more effective way to generate returns over such a timescale.

The fund had about a third of its assets in consumer companies at the end of February, although has less in the US than Fundsmith Equity and is more geographically diversified with 17 per cent of its assets in emerging Asian economies. It is also concentrated with 37 holdings. 

Federated Hermes Global Emerging Markets Equity (IE00B3DJ5K90)

Federated Hermes Global Emerging Markets Equity has a  strong performance record and provides core exposure to emerging markets’ structural growth drivers (see IC, 12 March 2021). However, it had assets worth £5.48bn at the end of February, and some analysts are concerned because it used to invest in small and mid-caps but now focuses on large-caps due to its size.

Also, its successful long-term performance is in part attributable to Gary Greenberg who last year stepped back from its day-to-day management.

However, size has not yet hindered the fund’s performance, and its lead manager is now Kunjal Gala, who has been co-manager since 2016 and worked closely with Greenberg for the past eight years. Greenberg will also continue to oversee the team until his retirement in 2022, and the fund has an established and repeatable investment process.

So there are good reasons to maintain your existing holding in this fund, but it could be worth investing new money earmarked for emerging markets elsewhere.

Hollands suggests Aubrey Global Emerging Markets Opportunities (LU1391034839), which had assets of $403.5m (£293.92m) at the end of February. The fund is managed by Andrew Dalrymple, John Ewart and Rob Brewis. They seek “to identify each stage of development a country is going through and the sectors that will benefit from this”, says Hollands. “These four stages are: rising prosperity, a behavioural change phase, an innovation stage and the economy reaching maturity.”

They like to invest in companies with market dominance that are local leaders, and have adequate enough cash-flow returns to support growth and reasonable valuations. They mainly invest in companies with market capitalisations between $1bn and £10bn.

At the end of February, the fund had about half of its assets in China and a third in India, so is less geographically diversified than Federated Hermes Global Emerging Markets Equity. And it had 37 holdings in contrast to Federated Hermes Global Emerging Markets Equity’s 57. Aubrey Global Emerging Markets Opportunities also had nearly 60 per cent of its assets in consumer companies while about a quarter of the Federated Hermes fund's assets were in these.

Marlborough UK Micro-Cap Growth (GB00B8F8YX59)

Marlborough UK Micro-Cap Growth has generated strong returns by investing in some of the UK’s smallest listed companies. But the fund’s success and investor inflows have resulted in it growing to a size of £1.4bn, as of the end of February.

“Microcap is an area you likely don’t want a large open-ended fund as there is a potential liquidity mismatch between its daily dealing and the low liquidity of its assets,” says Rob Morgan, pensions and investments analyst at Charles Stanley. “To combat it, managers may need to diversify considerably as fund size increases or move up the market cap spectrum, potentially missing good opportunities.”

A lot of this fund’s successful record has been down to Giles Hargreave, who ran it between 2004 and the end of last year. However, the fund’s current manager, Guy Feld, has run the fund for over nine years, working with Hargreave, and since January has been joined by Eustace Santa Barbara.

“The longstanding manager of this fund handed it to his co-managers, both of whom have run funds with him for many years and are experienced and excellent investors,” says Darius McDermott, managing director of research company FundCalibre. “We have no issues with the manager change of this fund but, if you are concerned about the size, an alternative is LF Gresham House UK Micro Cap (GB00BV9FYS80). It is much more concentrated than Marlborough UK Micro-Cap Growth, but is run by a very strong team that sticks to the sectors it knows best and has experience of private equity. This means that it often invests in very early-stage companies successfully.”

This fund had assets worth £283.9m at the end of February invested in 45 holdings – far fewer than Marlborough’s 180. It has been managed by Ken Wotton since its launch in 2009, who is supported by co-manager Brendan Gulston and a team of analysts.

“LF Gresham House UK Micro Cap fund is unusually concentrated for a smaller companies portfolio,” add analysts at FundCalibre. “This means investors are heavily reliant on the fund manager's skill in choosing the right investments. He mitigates this risk by undertaking rigorous analysis and only investing in profitable companies with low levels of leverage (debt). The fund is also deliberately small, which gives it the flexibility to exit positions relatively quickly and easily.”

ASI UK Smaller Companies (GB00BBX46183)

ASI UK Smaller Companies has a long and successful record thanks to manager Harry Nimmo who has run it since 2003. However, the fund had reached a size of £1.9bn by the end of February. And while Mr Nimmo has not indicated when he will retire he has scaled back his responsibilities, having stepped down as head of smaller companies at Aberdeen Standard Investments last year. So it could be worth diversifying a large holding in this fund.

Hollands suggests Henderson Smaller Companies Investment Trust (HSL) run by Neil Hermon, who invests via a growth-at-a-reasonable-price approach. “He targets cash-generative companies with growing earnings, while avoiding more speculative situations where it is difficult to value a business,” says Mr Hollands. “The trust leans towards sectors like industrials and financials rather than areas like tech or biotech.”

It had assets worth £931m at the end of February – less than half the size of ASI UK Smaller Companies – and in any case it has historically had more of a mid-cap focus. The trust has outperformed Numis Smaller Companies ex Investment Companies index in 15 out of the 17 financial years since Mr Hermon has been running it.

Artemis Income (GB00B2PLJJ36)

Artemis Income has a good record of beating the FTSE All-Share index and many of its peers, and pays an attractive level of income. But as of the end of February, it had grown to around £4.5bn. And a lot of its success is down to lead manager Adrian Frost who joined Artemis in 2002, since when he has run the fund. There is no indication that he is going to retire. And this fund, which is focused on larger and more liquid companies, could continue to do well in the foreseeable future. But it could still be worth investing new money elsewhere.

Options include Rathbone Income (GB00BHCQNL68), which had assets worth £794.3m at the end of February. It has historically been a more defensive UK equity income option, and has good performance and dividend-paying records.

The fund has been run by Carl Stick since 2000 and Alan Dobbie since 2018, and they are supported by a large team of analysts. They mainly invest in larger companies, although around a fifth of the fund was in small and mid-caps at the end of February.