Rees manages the five crown-rated Premier Multi Asset Distribution fund, which has been a top-quartile performer in the IMA Mixed Investment 20%-60% Shares sector over five years.
He says capacity is one of the starting points he and his team explore before investing in a fund.
Performance of fund vs sector over 5yrs
Source: FE Analytics
This year fund size has been one of the major talking points, with a variety of top-performing equity funds such as Aberdeen Global Emerging Markets Smaller Companies, BlackRock European Dynamic and Fidelity UK Smaller Companies all soft-closing over the past 12 months.
Rees commends managers who take action and stem inflows when their strategy is reaching capacity, as he says otherwise they will have to change their investment approach – something he claims is greedy and will inevitably hinder performance. “I think part of the understanding of it is what their natural bias and inclination is,” he said.
“Whether it is small, mid or large cap, we want to explore their possible capacity limit. Firstly, the manager needs to make people aware what the capacity is on the fund. Otherwise, the manager may be greedy and let the fund grow beyond a point where they have to change the way they operate.”
“The question is, does the manager want to maintain his or her approach or do they want to evolve their approach as the fund grows in size?”
“As a fund buyer, we want them to do the former as we don’t want the fund to change, we want it to do what we bought it for,” he added.
Rees says there have been numerous instances in the past where managers have chosen to change their approach rather than soft-close their fund.
“Findlay Park American is one example,” he said. “It started out as a fund that invested in very small US companies and then had to look up the market cap scale as it became goliath. It certainly was an example of a leopard changing its spots.”
“Neil Woodford is another, he was quite open to admit that he managed his fund very differently 15 years ago compared with how he manages it now it is a multi-billion pound portfolio,” the manager added.
Simon Evan-Cook, who co-manages the Premier Multi Asset Distribution fund and other portfolios with Rees, understands why funds can become too large for their own good but urges investors not to pile into ones that have already performed well.
“What we often see with funds, as in other areas of human behaviour, is a swamping of the lifeboat effect. Fund holders have an understandable urge to grab on to anything that’s seaworthy, with the paradox being that, if they all do, none of them benefit,” he said.
Evan-Cook says it is a dangerous assumption to think that the bigger the fund is, the better it will perform, as larger portfolios will usually be unable to replicate their past strong performance.
“Granted, larger funds do gain a small advantage from lower TERs, but the fact is that giant stars tend to be big because they have performed well, rather than performing well because they are big,” Evan-Cook said.
“In other words, don’t confuse cause with effect.”
“A massive fund can severely constrict a manager’s process: it takes him/her longer to get into and out of a stock because they own so much of it. So if a company goes wrong, they’re stuck with it.”
“It can also force them to buy larger stocks than before, or more of them – both of which can hinder their ability to outperform,” he added.
Rees says that one of the most recent notable examples where a fund has had to change its strategy due to capacity issues is FE Alpha Manager Paul Marriage’s five crown-rated Cazenove UK Smaller Companies.
It is the best-performing fund in the IMA UK Smaller Companies sector since Marriage took over in January 2006, according to FE Analytics, and has eclipsed the returns of its FTSE Small Cap ex IT benchmark.
Performance of fund vs sector and index since Jan 2006
Source: FE Analytics
Although Schroders decided to close the fund when it breached £1bn last month, Rees says he sold out of the fund before that because it had become far too big.
“We bought into Cazenove UK Smaller Companies when it was just £40m and we explored how much money it could take. We sold it earlier this year in the belief that it had become too big at £650m.”
“It didn’t alter our view on the manager, but he was having to buy larger companies because of the fund’s size,” he added.
Rees would prefer to see managers opening up from the start and saying their fund has a finite capacity, especially in the smaller companies space.
“In the small cap spectrum there are a lot of micro and fledging companies. Gervais Williams was one who set his stall out and said the fund couldn’t grow past a certain level, so when it did he closed it.”
“For a pure small cap fund, I think at £250m or thereabouts, you should start to look at whether you want to maintain you exposure,” he added.
Rees has been buying the Franklin UK Smaller Companies fund as a replacement for the Cazenove portfolio. It currently stands at just under £100m.
It had been a serial underperformer in the UK small cap space, registering bottom-quartile returns over three, five and 10 years.
However, it has been a top quartile performer since Richard Bullas and FE Alpha Manager Paul Spencer took over from Stuart Sharp in June last year.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
Franklin UK Smaller Companies has an ongoing charges figure (OCF) of 1.64 per cent and requires a minimum investment of £500.
