Bigger can be better, but not when managing money.
We have written before about how challenging it is to add value in the investment manager selection business.
Research finds that many who promote their ability to select superior investment strategies (consultants, fund of fund managers, and institutional investors) fail to find managers or strategies that outperform either their peers or an appropriate benchmark.
Previously, we summarized the findings of three different peer-reviewed academic studies from 2015, 2018, and 2020 (see links at the bottom under Related Reading). All can basically be summed up by the following finding from one of the papers:
“We find no evidence that [institutional investment consultant] recommendations add value.”
We have also discussed how anecdotal evidence suggests that once a manager is found, it is hard to allocate to them in a meaningful way without harming their performance.
In an effort to better test the idea that many discuss – that size matters – we found three more studies going back to the early 1960s that analyzed thousands of mutual funds and hedge funds over multiple market cycles.
In Does Fund Size Erode Mutual Fund Performance, researchers found that fund returns, both before and after fees and expenses, declined with fund size. As funds get large, a lack of liquidity can force managers into stocks that are more widely followed (informational edge declines) and to take larger positions that can be harder to nimbly trade.
Next, in The Life Cycle of Hedge Funds, authors found that Assets Under Management (AUM) explained 90% of the real-world performance of hedge funds. The study concluded that as AUM grows performance declines. They also documented how rapid asset growth is positively correlated with blow-ups and liquidations.
Finally, Capacity Constraints in Hedge Funds, details empirical evidence from over 7,000 funds. The paper shows – again – that larger amounts of AUM are negatively associated with performance.
In many businesses, being a dominant player with scale is an edge. Think of the power of a large retailer. By ordering in bulk, they can drive down the cost of the goods that they sell, which allows them to pass along savings to clients, increase their profit margins, or potentially both.
In the money management business, though, the larger you are the harder it is to exploit opportunities. You may be able to find good ideas but, if you are too large, when you trade you may move the price of the security up in a manner that erodes the attractiveness of a new purchase. Conversely, when you are looking to sell, if you are too big the size of the position you are looking to liquidate may exceed the demand of willing buyers. This in turn may take the price rapidly lower before you can get out at an optimal price.
Where does this all leave us?
We do believe that talented managers exist. Outliers are indeed among us and we should keep an eye out for them. In doing this, the key is to find them when they are just starting out. This brings on other challenges, however, that we wrote about with our fellow researcher, Joachim Klement.
“Size or capacity can be a real issue with managers, especially in some of the areas that offer the largest opportunity for alpha, such as small or micro-cap stocks.”
And to add value as an allocator of large amounts of assets…
“You have to be able to fund them without impacting the manager’s size in a way that reduces their edge.”
“Less is more and scale is your enemy.”
Bottom-line, bigger is not better in the money management business and the larger you are as an investor, the harder it is to allocate in a manner that keeps managers small.
Based on all of what we mention, and the independent research that backs it up, we continue to suggest that all investors, professionals included, be humble about our ability to add value through manager selection.
Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization – American Economic Review – 2004
The Life Cycle of Hedge Funds: Fund Flows, Size, Competition, and Performance – The Quarterly Journal of Finance – 2012
Picking winners? Investment Consultants’ Recommendations of Fund Managers – Journal of Finance – 2015
Fund of Fund Selection of Mutual Funds, Critical Review of Finance – 2018
Choosing Investment Managers – Swiss Financial Institute – 2020
How to Actively Add Value – Fiduciary Wealth Partners – 2021