Skip to the content

“Supertankers”: The reasons why you need to avoid giant funds

27 July 2015

Jon ‘JB’ Beckett tells FE Trustnet why investors need to wake up to the worrying development of giant funds and highlights the major risks associated with them.

By Alex Paget,

News Editor, FE Trustnet

Fund size has become a hotly debated topic within the industry, with many warning over the detrimental effect of a surging AUM to a fund’s performance and the possibility that – if unchecked – a manager will have to change his or her process in order to meet inflows.

In fact, fund size and greater transparency around a strategy’s capacity is something we at FE Trustnet hold dear and is an issue we will be writing about at length over the coming months – a campaign we know is already being backed by leading industry experts.

One expert who believes the trend of ever growing funds is becoming a danger is Jon ‘JB’ Beckett – UK research lead at the Association for Professional Fund Investors.

Beckett has close to 20 years’ experience in the industry as a fund analyst and researcher, having worked at the likes of Franklin Templeton and Lloyds. He has written a number of publications on the subject and in this article he talks through why the growing number of “supertanker” funds is becoming a very real problem within the industry.

 

The obvious problem with large and growing funds

The first and most obvious problem with a growing fund, according to Beckett, is the issue surrounding the “quality of its AUM” – a phrase that was coined by one his former colleagues Roland Meerdter.

He points out that there are two distinct issues with AUM quality, one of which is the changing dynamic of a fund’s investor base.

“As a fund becomes more successful and the ever increasing sales push to sell that fund to new markets increases, you get a deterioration in terms of the investor base. Your initial tranche of investors are very well suited to the fund strategy, your second, third are perhaps less so,” Beckett explained.

“The second, which should be immediately obvious, is from the fund manager’s point of view, as sometimes being thrown ever increasing amounts of cash is not always a good thing. What happens is fund managers have to try and contend with that new cash through increasing the tail of their portfolio at the risk of diluting their alpha.”

“Or, they have to contend with increasing asset exposure and increasing asset concentration.”

Of course, fund size has always been an issue and investors only need to look back to the experiences of FE Alpha Manager Andy Brough’s Schroder UK Mid 250 fund which, by the manager’s own admission, grew too large during the build up to the financial crisis.

Performance of fund versus sector and index between 2005 and 2009

 

Source: FE Analytics

However, Beckett says the dangers have only increased since then.

 


 

Why it is becoming a bigger issue now

Beckett says the most pressing reason why size is as big of an issue as it has ever been is because the global fund management industry has grown threefold over the past 12 years thanks general themes like the disintermediation of the banks, the effects of quantitative easing (QE), the outflow of defined benefit schemes and the knock-on effects of auto enrolment.

He also points to more industry-centric factors such as the open-ended nature of funds, survivorship bias and star manager culture.

“All these have really catapulted the global mutual fund industry. Why is this a bad thing? The industry is better than it has ever been before, it’s healthier, it creates jobs and it creates shareholder returns. All these things are absolutely true, but my response is simple – liquidity.”

“This is why we need to start thinking about size, blockbuster funds and supertanker funds.”

 

Increasing liquidity risk

Beckett says the major issue with a surging AUM is liquidity risk.

He describes asset liquidity as the prevailing price that an asset can be bought or sold at a sufficient trading volume to support the timely delivery of cash flow back to the fund manager at any given time.

Beckett then describes fund liquidity as the presence of enough active asset buyers and sellers to create sufficient trading volume to support the timely delivery and payment to the number of fund buyers and sellers at the same time.

“In this fairly simple ways, liquidity risk is the mismatch of buyers to sellers. It’s when an asset manager can’t realise his or her asset at the right price.”

“Andrew Stalker, who is the head of investment risk at Insight (someone I genuinely respect), reminded me a couple of years ago that liquidity is simply a function of price. If you don’t find equilibrium in your order book, you have no liquidity.”

“What you get, particularly during periods of market stress, is the fund manager simply having to chase the buyer down through the price range in order to find that liquidity and that becomes ever more compounded when we have periods of liquidity stress.”

 

There are advantages to being big…

Of course, Beckett understands why groups allow their funds to become behemoths within their sectors such as the fact they are top of the go to list for brokers and companies which are looking to float and they receive fund buyer bias

 “There are lots of advantages of being big. The first one is earnings, the second one is operational economies of scale and I absolutely buy that. Size in our industry means profit – but there are disadvantages of being big also.”

However, he says with size comes the greater chance of liquidity risk which, in turn, leads to the biggest potential threat – if that money which poured in when the going was good starts to head to the exit when markets begin to fall. 

 


 

The big disadvantage – redemption risk

“You can see why there has been this acceleration of asset concentration in our industry and yet it is the same buyers who then create the risk further down the road in the form of redemptions,” Beckett explained.

The analyst points out that during his time at Franklin Templeton, a number of the group’s funds became ever popular due to strong performance, a star manager and the fact the markets they concentrated on were very much en vogue.

The problem was though, according to Beckett, was it led to a very high concentration of redemption risk.

“One thing asset managers are particularly bad at, and I mean the distributers and marketing teams not fund managers themselves, is that they don’t realise that funds have different exposures to the market cycle and then if you put all your eggs in one particular basket and the cycle turns, then you are in a difficult position.”

He points out that asset management businesses want fairly stable asset expansion, coupled with a nice steady earnings path through the market cycle, so they aren’t overly exposed to the fortunes of one or two giant funds.  

“There is definitely a risk here of redemption risk and what has also been happening in the background is this move to individualism and investors now have much more control and say over their investments.”

“Unfortunately, the result of that (when you take into account social and conventional media) is then investors have the nature to want to behave irrationally and start to see herding patterns and very unhelpful investor behaviour during times of market stress.”

 

The best example of redemption risk – Pimco and Bill Gross

He says the best example of redemption risk was with Bill Gross’ PIMCO Total Return fund, which was the largest mutual fund of its type in the world at nearly $300bn in size.

While it had been a stellar performer, its huge falls during the so-called ‘taper tantrum’ in May 2013, when the US Federal Reserve warned it would reduce its QE programme, and Gross’s subsequent departure from the group meant money started pouring out of the fund – en masse.

“Through 2014 the fund lost close to $100bn. It is the largest single fund redemption in history,” Beckett said.

He points out that, in the face of growing redemptions, the fund began to display rising volatility (in fact its volatility broke two deviations bounds in September and December 2014).

“You could really start to see that redemption risk starting to feed through to performance, it was quite evident. The one figure that I will pick on is that £25bn which only outflowed in the month of September 2014. That is truly exceptional and the volatility spike in the fund during that period was, again, truly exceptional.”


 

Our data on the strategy is only the UK version of the PIMCO Total Return Bond fund, though as the graph below shows, the redemptions had a clear impact on its performance.

Performance of fund versus sector over 3yrs

 

Source: FE Analytics

“I’m going to make a very simple point here, while volatility is not a proxy for liquidity risk, if you see a period of unusual volatility what I am saying is ask the question ‘was it just a market movement or was there a liquidity issue underpinning it as well?’”

Beckett admits the major problem with the fund size debate is that funds have never been as large as they are today, so it is difficult to illustrate the potential pitfalls of investing in a ‘supertanker’.

However, in an article later this week he will tell FE Trustnet how to assess whether a fund has grown too large. 

ALT_TAG

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.