Two-fifths of investors are buying funds without giving any consideration to their size, according to the latest FE Trustnet poll. 

Forty per cent of respondents said they ignore assets under management (AUM) when they construct their portfolios, even though there are many funds that have suffered a decline in performance due to mass inflows. 

However, many of the industry’s largest funds, such as Neil Woodford’s Invesco Perpetual High Income, Standard Life GARS and M&G Optimal Income, are also among the best performing.

For obvious reasons, funds that have a history of outperforming their benchmark tend to attract huge inflows. 

However, there is a crucial tipping point where, due to certain issues with liquidity, a fund can run into problems and the huge size has a detrimental impact on performance.

For example, if a manager of a giant fund suddenly decides he no longer wants to be invested in a certain stock then he is likely to find it difficult to scale back his position if there are not enough buyers for the huge number of shares he owns. 

Another problem is that large funds tend to get pushed up the capitalisation scale because if they try to take positions in small companies then they can all too quickly become majority shareholders.

Hargreaves Lansdown’s Rob Morgan says this is a problem he has seen throughout the industry. 

"Artemis UK Special Situations is a fund which had a tremendous time," he commented. "Manager Derek Stuart was adding value in the small and mid cap space and, as a result, attracted inflows." 

"We can’t be sure that size is the reason for performance taking a dip but we do know that it is now looking more like a large cap portfolio and that is likely to have an impact on his style."

He added: "It also goes the other way. Tim Steer was running a large cap fund at New Star before he moved to Artemis. Now his UK Growth fund has a much bigger focus on smaller companies and he has fared much better."

Soft-closing a fund when it reaches this point is its best option; however, fund houses are likely to want to strike a balance between collecting management fees and protecting performance. 

"We ask managers all the time at what fund size they think their style will begin to struggle," continued Morgan. "So long as we keep monitoring it then we can challenge them on it when it starts to look a bit big." 

First State Global Emerging Markets, Standard Life UK Smaller Companies and Trojan are just three high-profile funds to have shut the door to new money. 

Aberdeen also wrote to financial advisers earlier this year to ask them to stop promoting its two emerging market funds.

FE Alpha Manager Francis Brooke, who runs the top-performing Trojan Income fund, has told FE Trustnet that he doesn’t feel it would be possible to maintain his style with more than £2bn AUM.

Morgan says that while investors must always be wary of the size of the fund, it won't always impact performance. This shows the importance of understanding a manager’s style. 

Performance of fund vs sector and benchmark over 3-yrs



Source: FE Analytics 

Morgan added: "A fund like M&G Optimal Income is massive and investors can’t reasonably expect Richard Woolnough to add value through individual company credit positions because it is so hard for him to deal, but his real strength is in the wider, macro asset allocation calls."

"He’s shown a real ability to add value there."

Artemis Special Situations had a strong five years following its launch in March 2000, delivering 156.14 per cent compared with losses of 7.3 per cent from its FTSE All Share benchmark. However, in the last three years the portfolio has fallen significantly short of the index.