Fund size is a much debated topic within the industry, with the best performing portfolios often quickly becoming the most bought by investors and many warning about the negative impact a soaring AUM can have on future performance.
Of course, capacity is all relative as managers running funds which focus on mega-caps or have a very flexible mandate have a huge amount of liquidity available to them.
Within the small-cap sector, though, capacity can become very important very quickly if a manager wants to buy the smallest businesses in the index.
A surging AUM in small-cap land can mean that managers have to either take significant individual stock risk, increase the number of holdings to accommodate greater inflows or simply move up the market-cap scale to find more liquid opportunities – all of which means the once top-performing manager has to change the approach that was so successful in the first place.
However, given funds have never been as a large as they are today, there aren’t too many examples of when a portfolio’s size has categorically hindered performance.
In fact, data from FE Analytics shows an equally weighted portfolio of the largest IA UK Smaller Companies funds at the start of this upward phase in markets (February 2009) has since gone on to comfortably outperform a similarly weighted portfolio of the smallest funds in the sector.
Performance of large versus small funds and sector since February 2009
Source: FE Analytics
Nevertheless, apart from three funds in the 10-strong portfolio of the ‘giants’ in the sector at that time (which we will look at more closely in this article), none of them have seen extreme inflows and still weigh in below £500m – such as Artemis UK Smaller Companies, Baillie Gifford British Smaller Companies and BlackRock UK Smaller Companies.
On the other hand, while the ‘small’ portfolio includes some top-performers such as the R&M and Schroder (formerly Cazenove) offering, it also includes perennial underperformers such as SF Webb Capital Smaller Companies Growth which has somehow lost 24 per cent over that time.
When you exclude that fund from the data, the portfolio of the smallest funds has actually outperformed its largest rivals by 25 percentage points.
Performance of composite portfolios since February 2009
Source: FE Analytics
On top of that, advocates of the ‘size affects performance’ argument point out that giant funds don’t immediately underperform but that increased inflows gradually dilute the manager’s ability to generate alpha.
When you look at the sector today, there are three funds that stand out in terms of size and the commonality between them is that they are all run by very highly rated managers who have comfortably outperformed over the long term.
Harry Nimmo, Giles Hargreave and Daniel Nickols (who are all FE Alpha Manager ‘hall of famers’) are very deserving of their status.
Hargreave, for example, has beaten his peer group composite in 14 out of the last 15 calendar years, making him the most consistent FE Alpha Manager of the millennium, while his Marlborough Special Situations fund has comfortably topped the sector since he took charge in July 1998 and beaten the average fund by more than five times.
Nimmo’s Standard Life Investments UK Smaller Companies fund, despite a period of poorer performance over recent times, is still the second best performing portfolio in the sector since he took charge in January 2009.
Nickol’s Old Mutual UK Smaller Companies fund is also top decile since he assumed responsibility for the portfolio in January 2004, beating its Numis Smaller Companies ex IT benchmark by more than 150 percentage points.
All told, the three managers are a cut above the rest in terms of performance, as the graph below shows.
Performance of funds versus sector over 10yrs
Source: FE Analytics
However, those three funds mentioned are now the three largest in the sector and, combined, the managers now run a quarter of the assets in the sector – which is made up of 51 funds.
Nimmo’s fund currently weighs in at £1.2bn while his mirror investment trust is £266m. Nickols runs £837m in his Old Mutual UK Smaller Companies and a further £140m in his Dublin-domiciled UK Smaller Companies Focus fund, which is a more concentrated version of his flagship offering.
Marlborough Special Situations is now £930m but Hargreave and his team also run a whole host of other small and micro-cap offerings within their stable.
Is this a worry to investors and are these funds likely to underperform now they are giants within the sector?
Simon Evan-Cook, senior investment manager at Premier, holds fund size close to his heart and while he says those three managers are some of the best available to investors, he avoids them because of the size of their funds.
“I wouldn’t say I have an issue with calling them small-cap [funds] as they still give investors exposure to the asset class and in terms of looking for best in class, you are looking at one of these managers,” Evan-Cook said.
“That’s said, we would prefer to back them 10 years ago when they were running funds which were much smaller because that is when they were in the sweet spot. I’d say they are now a little bit limited in terms of taking out a large position in a genuine small-cap because of their size.”
He added: “If that’s the case, then it is not unreasonable to think that their alpha generation isn’t going to be as high as it could be.”
Little is known as to whether it is due to the size of the funds, but all three have performed more in line with the sector than they have done over the longer term during a period when their AUMs have surged.
Marlborough Special Situations has nearly doubled in size over the last three years (£472m to £930m) and is second quartile over that time while the same has happened to Old Mutual UK Smaller Companies, which has grown by £475m to £852m and sits in the second quartile.
Standard Life UK Smaller Companies, on the other hand, has been one of the largest in the sector for a number of years now, standing at more than £1bn three years ago. It grew to £1.4bn by March 2014 and has since shrunk following a period of underperformance.
The fund is underperforming the sector over the past three years by 7 percentage points.
Performance of funds versus sector and index over 3yrs
Source: FE Analytics
A spokesperson from Standard Life Investments points out, however, that Nimmo has always looked to ‘run his winners’ meaning he won’t sell a stock just because its market cap has increased. For instance, he held Hargreaves Lansdown all the way until it grew into a FTSE 100 company. 
“The smaller companies team’s investment philosophy of ‘buying tomorrow’s larger companies today’ and ‘running your winners’ translates into a long-term, low turnover investment style. This lends itself to managing a larger pool of assets compared to many funds within the sector.”
The spokesperson also says liquidity within the fund is monitored regularly and that Nimmo’s avoidance of micro-caps helps capacity.
Ben Willis, head of research at Whitechurch, has told FE Trustnet in the past that while he rates Nimmo highly, investors buying now should know they aren’t necessarily getting an out-and-out smaller companies fund because the manager has significant mid and even large-cap exposure.
It currently has 57 per cent in the FTSE 250, for example.
Nickols also disagrees that he is facing any potential liquidity issues and he says he can continue to outperform with his current AUM.
“We have been running a large pool of assets in the UK small-cap space for a long time and as such, there is no evidence that the size of the funds is a barrier to performance,” Nickols (pictured) said. “The team is very used to running money in this space in such a way that we can reposition the funds when conditions change, in my view.”
Hargreave and his team, on the other hand, have always run very diversified portfolios with Marlborough Special Situations currently made up of 217 stocks. The fund’s largest holding accounts for just 2.43 per cent of Hargreave’s total assets as well. 
“Marlborough Special Situations has an investable universe of more than 2,000 stocks and Giles Hargreave (pictured) works with a sizeable team who are constantly identifying new ideas for investment,” Marlborough said.
“That, combined with the fact that the fund holds more than 200 stocks, with the largest position only around 2.5 per cent of the portfolio, means the strategy is highly scalable and plenty of scope remains to accommodate inflows.”
Nevertheless, while Evan-Cook agrees that these funds will continue to perform okay over the coming years, he thinks size will start to take its toll.
As a result, he thinks there are better, more nimble opportunities within the sector that can give investors more direct exposure to genuine smaller companies and therefore outperform in the process.
“They have all proven they are excellent managers and their funds are not ‘uninvestable’ by any stretch of the imagination. However, from our perspective, we would prefer to buy funds which can take decent positions in their best bets without being constrained by size,” Evan-Cook said.
In an article later today, FE Trustnet will take a closer look at three of up-and-coming nimble funds within the sector which have the potential to challenge the old guard.
