Outperforming funds inevitably take on mass inflows once the word gets out that they are outpacing their peers. A rush of inflows can be particularly dangerous for small cap portfolios, which often end up having to either buy large positions in small companies or move up the market cap scale to maintain liquid positions.
Dampier says that once a fund reaches £500m, it becomes very difficult for it to take meaningful positions in smaller companies without leaving itself holding a massive share of the company.
"For small cap funds, when they reach about £500m to £600m they will probably be saying no to anything below £100m," he said.
"Huge positions in small caps are more dangerous because you’ve got no chance of getting out at all."
Sometimes managers effectively end up as majority owners of a company’s shares, which can be particularly problematic.
However, Dampier says this is not always a reason to sell out of such a fund. He says investors should not always be concerned about funds that have big stakes in companies.
"I could say that about Neil Woodford," he said.
"He has quite a few positions further down the portfolio where effectively he’s the owner of the business."
There is little transparency about a fund’s holdings below the top-10, which makes it difficult for investors to keep an eye on this problem.
Managers are only required to publish portfolio information every six months, meaning investors are often left with just the top-10 to consider.
Even looking at those positions, however, it is evident that small cap managers often end up holding a large amount of a single company.
FE Alpha Manager Harry Nimmo has a highly concentrated portfolio of 50 to 60 stocks in his four crown-rated Standard Life UK Smaller Companies fund, nearly 40 per cent of which are in his top-10.
This means the manager’s largest 10 positions total £448m on a £1.2bn portfolio and underlines the point that to run a small cap fund of that size the manager has to hold big positions in individual firms.
Paul Marriage has a similar concentration in his five crown-rated Cazenove UK Smaller Companies portfolio, although only a quarter of the fund is in his top-10 bets.
The fund is edging above £500m, which makes for some substantial positions in small caps.
However, Dampier says if the manager has experience and conviction in a single stock, such as FE Alpha Manager Nimmo with Asos, investors do not need to be too concerned about big positions.
He says they are buy-and-hold managers who do not pile into a company with the intention of unwinding the position in the near future.
"[Nimmo] doesn’t trade very much so it doesn’t matter about having a large position because you’re not planning on getting out of it," he said.
One example of Marriage’s highest-conviction bets in his top-10 is Walker Greenbank.
Although the household goods and home construction firm makes up just 2 per cent of Marriage’s portfolio, due to the size of his fund the manager owns roughly 14 per cent of the company.
Marriage has a similar stake in his ninth-largest holding, support-services firm Staffline.
Since Marriage took over the fund in January 2006, the fund has been one of the best-performing in the IMA UK Smaller Companies sector, returning 141.39 per cent.
The sector and FTSE Small Cap ex IT index have gained just 49.6 per cent and 13.62 per cent in this time, respectively.
Performance of fund vs sector and index since 2006
Source: FE Analytics
Dampier says that holding a big position in a company is one method managers have of beating their benchmark.
"If you have experienced fund managers, sometimes they get it wrong, but you’ve got to do something different to beat an index."
"You’ve got to be doing something quite different to the benchmark to beat that benchmark," Dampier said.
However, he says it should raise red flags if managers are taking big positions and have a high turnover.
This type of liquidity concern is something Fidelity has obviously taken seriously with FE Alpha Manager Alex Wright’s Fidelity UK Smaller Companies fund.
The firm moved to soft-close the outperforming portfolio at £280m after it took on more than £100m in a matter of months.
Over the last year, the four crown-rated fund is the best performer in the IMA UK Smaller Companies sector, picking up an impressive 58.75 per cent.
The sector gained just 27.03 per cent while the fund’s benchmark, the Numis Smaller Companies ex ITs index, made 37.09 per cent, according to FE Analytics.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
Dampier says he expects the pace of soft-closures to ramp up as the best-performing funds take on too much money to operate effectively.
Marlborough Special Situations is one of the fast-growing funds that has moved up the market cap spectrum to preserve liquidity, as FE Trustnet reported in March.
Earlier this week, FE Trustnet carried warnings from industry experts that many of the best funds were soft-closing, limiting investor choice.
