Asset allocators face a “perverse incentive” to act against investors’ interests by backing larger funds over their smaller counterparts, according to Adam Rackley, manager of VT Cape Wrath Focus.
Smaller funds have a key advantage over their larger peers, in that their managers can establish high-conviction positions quickly without having to buy a stake so big it restricts their ability to quickly sell out should the need arise.
Dan Cartridge, an assistant fund manager at Hawksmoor Investment Management, recently wrote an article explaining this in more detail.
“Managers of smaller funds can both buy and sell quickly without moving the price,” he said.
“Managers of large funds often have to chase prices higher to establish meaningful positions, and chase prices lower in order to sell out of positions, which over the long term can be a big detractor to relative returns.
“Crucially, for some large funds, the issues highlighted above will simply preclude them from investing in many smaller companies and bond issues.”
He added that these are typically under-researched parts of the market where both inefficiencies and the opportunities for active managers tend to be greatest.
“In short, smaller funds typically have a broader investible universe which, all else equal, bestows them with another important competitive advantage over their larger peers,” he said.
At just under £8m in size, the problems faced by larger funds are unlikely to become an issue for VT Cape Wrath Focus any time soon. Nevertheless, when he set up the fund, Rackley announced he would soft-close it at £100m and hard-close it if it ever reached £200m, to ensure his high-conviction value process would never be compromised.
He admitted this approach was “bad for business”, which is why there is a push against capacity constraints from asset managers – the more money they run, the higher their profits. However, he said most asset allocators tend to be opposed to them as well.
“We're thinking about the underlying client, and for them, having a capacity constraint is never a bad thing,” he explained. “But we access the underlying client through allocators who have lists, and in order to get on those lists, you need to have a certain amount of capacity, otherwise it's not worth them doing the work.
“There's definitely a lot of doors closed to a fund that says, ‘we've got a low capacity because we want to focus on performance’, which is counterintuitive – it is a perverse incentive, really.
“The allocators and the industry are pushing in the opposite direction to what's really in clients’ interests.”
One reason why major asset allocators may be reluctant to invest in small funds is liquidity – if they are running many billions of pounds of investors’ money, they are likely to have concerns about how quickly they could pull their money out in a crisis.
Rackley said that the liquidity of the underlying holdings is more important than the size of the fund, adding: “If we needed to, we could sell 40% of the fund in one day. So for our underlying investors, liquidity isn't an issue at all because we can take the money out instantly.”
So what do the asset allocators say? Trustnet approached two of the most prominent investment platforms in the UK, AJ Bell and interactive investor, which offer either ready-made model portfolios or their own funds of funds. Both also have recommended funds lists. When asked for their opinion on Rackley’s “perverse incentive” quote, their responses were brief and not entirely relevant.
Dzmitry Lipski, head of funds research at interactive investor, said: “It makes sense for managers to soft close when assets grow, which could potentially impact the opportunity set and performance as a result. But it’s very unusual for a fund manager to close at £200m.”
A spokesman from AJ Bell said: “The fund is £8m in size so it’s quite a long way from having to worry about capacity,” adding he “wasn’t sure what evidence shows it is better for the end investor if the fund stays small”.
The platforms were more forthcoming on fund performance fees – VT Cape Wrath Focus charges 20% of any outperformance of its benchmark, with a high watermark.
Rackley defended this by saying this means he doesn’t need to blindly chase assets, adding: “The way we have structured it, we don't make any money unless we deliver performance. And the insurance against us being managers who just swing the bat to try to get performance is that all my investable net worth is in the strategy as well.”
A spokesperson at interactive investor said that they had no issue with performance fees as long as they are sensibly set, do not encourage excessive risk taking, and have short- and long-term measurements and incentives.
“Get that right, and the interests of the manager can be sensibly aligned with shareholders,” they added. “Get that wrong, and you face potential shareholder detriment and reputational damage – not just for the trust or fund in question, but for the wider sector.”
Ryan Hughes, head of investment partnerships at AJ Bell, was more opinionated, calling performance fees “unnecessary” for retail investors given the complexity involved.
“Terms such as high watermarks and hurdle rates mean nothing to most investors, while large performance fees after a period of good performance also create a significant image problem when the fund then significantly underperforms,” he said.
“As a result, where there are performance fees, I’d ideally like to see them capped. While we do use some funds that have them in place, we have not added any new products that charge a performance fee for some time and in an ideal world, they wouldn’t be seen in retail investment funds.”