Model portfolios have grown in popularity since the introduction of RDR, with many advisers preferring compliant one-stop-shop risk-rated portfolios instead of selecting funds in-house.Potter himself runs a range of actively managed funds of funds, but thinks there is a concerning amount of overlap in the model portfolios run by large discretionary and wealth management firms.
This, he says, has seen a number of top-performing funds grow to unmanageable sizes.
He says buying funds based on past performance and a “safety in numbers” mentality are to blame.
“There seems to be an idea that buying big funds is lower risk, but that just isn’t the case,” he said.
“There’s the idea that larger is safe. They are in larger stocks with more liquidity, but if everyone walks to the door at the same time, there can be very big shocks.”
“What concerns me is that because of regulation there are big issues of TCF [treating customers fairly], but that’s not the same as protecting your backside and backing large funds with a good track record.”
Potter (pictured) says stricter regulation in the aftermath of RDR has done some good, but regrets that it has led many industry professionals to prioritise box ticking over performance.
“It seems that in many cases performance is third or fourth down the list of priorities. You’ve got profile, size, liquidity, and only then do people start thinking about performance,” he said.
“Dare I say it, but I think that you’ve got a situations where there are people coming in running model portfolios and they have been schooled in a way that means they believe that bigger funds are better.”
He says he understands why large discretionary firms are unable to hold small funds, but says this does few favours for those who invest in their model portfolios, or the existing investors in the funds that get too big.
“In some ways they are victims of their own success. If they put a smaller fund in and it goes into every model and every office across the country owns it, then they’ll have a meaningful stake in that fund,” he said.
“Now I don’t personally see what the big problem is with that, but some will say they can’t invest in one that’s £200m in size or smaller.”
“The question they are asking is ‘can I buy it and sell it easily?’ They’re not looking at the quality underneath.”
Potter says he and his team target managers with as much flexibility as possible to outperform, including those in his £990m F&C MM Navigator Distribution portfolio.
“Funds like M&G Optimal Income, Invesco Perpetual Corporate Bond and so on are very good funds, but we’d rather be in smaller funds with more flexibility. Majedie Income, BlackRock Global Funds Asian Growth, Hermes Global Emerging Markets and so on,” he said.
“I look at the performance of Majedie UK Income versus some of the big boys, and that is what people are potentially missing.”
Performance of fund, sector and index since launch
Source: FE Analytics
“Why do the big funds always win the awards? Because everyone who owns them in the models are voting for them. We try and keep one step ahead.”
Ian Rees, a fund of funds manager at Premier, agrees that the rise of model portfolios is contributing to the problem of fund size.
He says more blame should be levelled at the asset managers who aren’t quicker to close the funds before performance is compromised.
“Buy lists are very short, which is creating clustering,” said Rees, who runs the £412m Multi Asset Distribution portfolio.
“The assessment of most funds and buy-lists is based on historic total return. When a fund has performed well and starts getting noticed, it is a much safer option to ‘follow the herd’ rather than seek to identify tomorrow’s fund superstars.”
“With regard to fund size, the ideal scenario is to find managers who are aware of the scale of their own expertise and can set capacity accordingly so that their individual investment process can still operate.”
“We believe this helps maximise the performance potential of managers and is an approach often adopted by boutique fund groups where maintaining attractive performance is of greater importance than asset gathering.”
Potter agrees that some groups need to do more to protect existing investors, but says strict capacity limits are unrealistic.
“Absolutely some of the blame has to go to the groups, and I applaud those that close funds early,” he said.
“There needs to be pragmatic soft-closing controls. If a fund has a limit of £1bn and the market doubles over five years as it has done, then that limit is no longer relevant.”
“The problem is when asset management companies hoover up assets because of investors using their rear-view mirror.”
He points to Prusik Asian Equity Income, which is $856m and already closed to new money, as a fund whose capacity has been managed very well.
The likes of the Newton Asian Income fund is almost £5bn in size, and has struggled to keep up with its smaller rival in recent years, or indeed its benchmark.
Performance of funds and index over 3yrs
Source: FE Analytics
Simon Evan-Cook, who works with Rees on the fund of funds team at Premier, is frustrated by the flood of money going into certain funds, as it dilutes the performance of talented managers.
“I assume a lot of this is down to a greater concentration of fund buyers, and those fund buyers all looking for similar features,” he said.
“In some ways this is encouraging, because at least they are buying good funds rather than bad ones. The trouble is, in this winner-takes-all environment, a flood of assets can easily turn that good fund into a bad one.”
“Model portfolios and buy lists should take account of fund size in their expectations for future returns. It is naive, for example, to expect a £2bn smaller companies fund to be able to reproduce the stellar outperformance it created when it was £50m in size.”
He believes the lack of action from fund groups to close burgeoning portfolios will eventually come back to haunt them.
“Professional fund buyers who are burned by holding a fund that collapses under its own weight will never return to that fund, and are likely to be wary of the group that provided the fund too. Call it investment karma if you like,” he said.
As well as boutique groups such as Miton, Somerset and Prusik which have been quick to close funds to new money, Evan-Cook highlights Fidelity as a good example of a company that manages capacity well.
“Perhaps it’s the result of their bad experience of splitting Anthony Bolton's fund in the noughties. Recently they have acted quickly to soft close popular funds before they fall apart,” he said.
“We like to find and back good managers early such as Alex Wright on his Fidelity UK Smaller Companies fund. It is reassuring when a group stops that fund from being ruined for original investors, by stopping late adopters from swamping the boat.”
Fidelity soft-closed Wright’s fund back in April 2013, when assets stood at £250m.
Performance of fund and sector since Apr 2014
Source: FE Analytics
FE data shows the fund has continued to outperform its peers since the decision was made.
Whitechurch’s Ben Willis, who runs a number of model portfolios for the firm’s discretionary service, admits that the issue of fund size is becoming more and more challenging.
When groups soft-close funds he and his team are often forced to take them off their buy-list, which he says makes it crucial to keep a lookout for up-and-coming managers.
“Yes, there is some laziness out there. We do all the research ourselves so we hope that we can add some value and find those off the beaten track,” he said.
“We do have some funds that you may call core holdings, but most of those we have held for a long time. It’s an ongoing challenge to look at the funds that are stars of the future, and to do that you need to do a lot of research and networking with the likes of Ian Rees.”
Willis admits that the style and performance profile of funds do change as a result of mass inflows, but says that doesn’t mean you should automatically sell out of them.
“Something like Newton Asian Income has evolved for us into more of a core holding in a medium risk income portfolio,” he said.
“Now the challenge is to find more of a satellite holding which is a bit more aggressive, in the way Newton Asian Income was.”
