Our data shows that an equally weighted portfolio of the largest IMA UK Equity Income funds as of January 2009 has returned 88.4 per cent over five years, while the average fund in the sector has returned 104.29 per cent.
Performance of composite portfolios vs sector over 5yrs
Source: FE Analytics
According to FE Analytics, apart from Schroder Income which was £877m in size five years ago and is a top-quartile performer over this time, and M&G Charifund (£1bn) which has been second quartile, the other 10 funds in the portfolio have underperformed against the sector over that time.
Among the worst performers have been Newton Higher Income and FE Alpha Manager Neil Woodford’s Invesco Perpetual High Income fund – which were both multi-billion portfolios five years ago – which have registered bottom-quartile returns over the period.
The research shows that investors who bought into the smallest IMA UK Equity Income funds five years ago would now be much better off, with FE data showing that they have returned 131.99 per cent since then, beating the sector average by 27 percentage points and the portfolio of larger funds by 44 percentage points.
Among the smallest IMA UK Equity Income funds five years ago were Unicorn UK Income, PFS Chelverton UK Equity Income and Standard Life UK Equity Income Unconstrained, which all have a mid or small cap bias.
They have also been the three best performing funds in the sector over the last five years.
Fund capacity has been a major talking point in the industry over recent years, with a number of top-performing funds deciding to close their doors to new investment while others have seen their assets under management (AUM) surge.
The common view is that smaller funds will ultimately outperform larger ones as they are more nimble and can dip into all areas of the market without taking on liquidity risk.
This view seems to be correct, according to the study.
The fact that the list of smaller funds by AUM is made up of a number of multi-cap portfolios seems to be the major reason why they have outperformed.
Since the period after the financial crisis, small and mid caps have vastly outperformed their large cap rivals due to lower starting valuations, an improving economic backdrop and increased investor appetite.
Performance of indices over 5yrs
Source: FE Analytics
Larger funds find it harder to invest in those areas of the market due to liquidity concerns, but the smaller funds at the start of the period covered in the study tend to have a strong bias to this area.
Some cautious investors stick with large cap biased funds because the perception is that they will protect capital better on the downside.
The downside protection argument also seems to hold true, according to the study.
Investors over the last five years have seen almost uninterrupted gains, except in 2011 when the concerns over the eurozone crisis deepened.
The portfolio of larger funds lost 1 per cent that year while the portfolio of smaller funds fell further, losing 5 per cent.
On top of that, larger funds have been much better for maximum drawdown – which shows how much worse off investors would have been if they had bought at the highest price and sold at the lowest – than their smaller rivals over that five-year period.
However, many investors buy into the biggest funds in the sector as they see them as safer, more dependable choices.
This study seems to illustrate the dangers of simply buying into the most popular funds.
Simon Evan-Cook, senior investment manager on Premier’s Multi Asset Team, recently told FE Trustnet that many investors wrongly assume that larger funds are superior.
“What we often see with funds, as in other areas of human behaviour, is a swamping of the lifeboat effect,” he said.
“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.”
Despite this, Evan-Cook says investors shouldn’t just buy into smaller funds in the hope they will naturally outperform over time.
Instead, he says it all comes down to the ability of the manager.
“That’s absolutely our position,” Evan-Cook said.
“It’s really about pro-active fund management, by which I mean picking the best fund managers out there. There isn’t a blanket argument that smaller, more nimble funds can outperform larger ones. The problem that can occur, of course, is if you find a great manager and they perform well but then other investors recognise it and collate around the fund.”
“The bigger funds have usually grown because the manager has performed well. Take Neil Woodford, for example, but it gets to a stage where the manager finds it more difficult to manage money as the fund becomes bigger.”
“On the other hand, some funds are small – and will stay small – because they are terrible,” he added.
One such fund that has outperformed massively, but has also grown by a considerable amount, is Unicorn UK Income, headed up by FE Alpha Manager John McClure.
Although the study doesn’t differentiate between the impact of NAV performance and inflows on a fund’s assets under management, Unicorn UK Income was just £1.6m in size five years ago and currently stands at £563m.
The five crown-rated fund has been the best performer in the sector over three and five years and the fifth best performer over five years.
It has also comfortably beaten its FTSE All Share benchmark over each of those time frames.
Source: FE Analytics
While the fund has increased in size by 35,087 per cent over the last five years, the majority of that growth has come within the last year or so; it has grown by more than fivefold over this time.
Evan-Cook says that it is quite difficult for managers running a smaller fund to predict at what size they will reach capacity, because when AUM are under £10m, it is difficult for them to conceive of this figure growing to more than £500m.
He says the only way to work out whether a fund has reached its limit is to see whether or not the manager’s investment style has changed.
“When a manager has sold out of a position and can’t re-stock, that’s when the amber lights start flashing. You have got to question how that change in style is going to impact returns and whether they will be able to perform as well as they have done in the past,” he said.
“We do see that sort of thing a lot, so we will always try and pin them down to a number and if the size surpasses that, then we would have to take a closer look,” he added.
While McClure told FE Trustnet he was happy with the size of his Unicorn UK Income fund and expected to outperform in the future, he did admit that he could no longer buy some of the smaller stocks that had been the portfolio in the past.
For investors looking for decent core exposure to the highly popular UK equity income market, he says they should always focus on the quality of the manager.
However, he says this sort of strategy will have a capacity limit.
“In terms of a core UK Equity Income fund that is all cap with a large cap bias, £3bn is when we would start to become concerned and look to change out into something else,” he explained.
