In life, it is often better to be big. We learn this early on in the playground, as bigger boys and girls tend to intimidate or bully smaller boys and girls. In later life, research has found that big or tall people are more likely to secure the best jobs. In the corporate world, big companies have a habit of gobbling up smaller companies or using their greater muscle and size to gain a competitive edge.
But in fund management, being smaller has advantages. Size is also becoming more of an issue as the asset management industry grows. PwC, the professional services firm, forecasts assets under management globally will rise to more than $100tn in 2020 from $64tn today.
There is a temptation, therefore, as more money flows into the industry, to increase the size of already big funds with billions under management into leviathans.
This should be resisted, as smaller funds produce better returns. Research by Simon Evan-Cook, senior investment manager at Premier, the UK asset management group, makes this point by using Invesco Perpetual’s Neil Woodford, himself a leviathan of the fund management industry, as an example. As his celebrated UK equity Income fund has grown, its performance has suffered.
Over the past five years, the fund has only beaten the market by 0.2 percentage points compared with about 80 percentage points over the five years to 2003 when the fund was roughly a 10th of the size. The Income fund has £9.4bn in assets today compared with £1.06bn at the end of 2003.
Mr Woodford’s poorer performance as his fund has become bigger is mainly because he now holds more large companies at the expense of smaller ones.
In 2003, the Income fund was more than 60 per cent invested in mid and small-caps, with the rest in large-caps. Today, less than 25 per cent of the portfolio is in mid or small-caps, while more than 75 per cent is in large-caps.
In other words, the experience of Mr Woodford suggests asset managers should keep their funds smaller, so they can have a bigger weighting in small and mid-cap companies. Why is this?
First, outperformance in large-cap companies is harder to achieve because they are more efficiently priced, while their growth is limited as they already have size.
Second, it is much harder to take a meaningful position in your best ideas when you have billions under management with a large chunk of your portfolio in large-cap stocks. This is because you have a much smaller proportion of the stock compared with the size of your fund. Hence, when the stock price rises and your strategy has been proved correct, your gains are much less impressive than they would have been with a bigger proportionate stake in a smaller company in a smaller fund. As Mr Evan-Cook puts it, picture the difference between a stock price doubling when it represents 4 per cent of your portfolio, and then when your exposure is just 0.04 per cent.
Third, a big company is more reliant on macro conditions for outperformance, as large-cap stock prices are predominately influenced by what is going on in the wider economy. This is difficult to predict even by the most experienced fund manager and this makes returns harder to come by.
Is it a coincidence that Mr Woodford is departing Invesco at the end of April to set up his own funds in conjunction with Oakley Capital, just as his performance has dropped? Indeed, some speculate that Mr Woodford’s new funds will be much smaller. When you add his High Income fund at Invesco to his Income fund, which are in effect the same portfolio, it amounts to a whopping £23bn.
Small is therefore cool, or at least it is in fund management. This is a refreshing fact in a world where everything – from people to companies – seems to be getting much bigger.
David Oakley is the FT’s investment correspondent
Get alerts on Fund management when a new story is published