But from this position can come great things – smaller funds are frequently more innovative than their larger peers and provide attractive returns in their early years.Investors who identify and invest in such propositions in their infancy can benefit greatly. Therefore, it’s a shame that blind interpretation of regulation, the rise of trackers and job insecurity are combining to create a perfect storm against these funds.
The first force comes from RDR, and the advent of prescribed risk models. This is supposed to provide a clear framework for assessing the risk and return potential for a client’s portfolio and in turn the underlying funds.
Large swathes of the market, and in particular most discretionary fund management propositions, have opted to blindly follow this risk framework, regardless of its bias towards certain asset classes.
Yet a profiling technique that uses an overview of the last 10 or 15 years of returns to determine its risk/return framework will show a distinct bias away from equity, which arguably has a better forward-looking performance profile, towards fixed interest and property.
In simple terms, no weight will be assigned to forward-looking measures, which are the key drivers of expected asset-class returns.
Hence we have witnessed huge inflows into funds that favour the latter asset classes in the expectation that this bias is a permanent feature. In my mind, this is creating an overemphasis towards the "return-free risk".
As these approaches rely on past returns, they cannot incorporate new funds. Equally, many portfolio managers restrict the funds that may be incorporated in a portfolio by imposing an arbitrary fund-size threshold, without consideration to the liquidity of the underlying asset class.
The unintended consequence of this RDR assessment process leaves many small but very good funds overlooked.
Using artificial "rules of thumb" as opposed to methods that more accurately measure a fund’s potential, is a dangerous path to follow. We need to foster new managers who will become the stars of the future.
The well-known, respected, highly rated fund managers had to start somewhere, and cannot go on forever.
ETFs are also having a significant impact on the industry. They are readily eating into large swathes of so-called active fund management – which has been recognised as Beta masquerading as something else – and are putting cost pressures on fund managers, which can benefit investors. However, if such cost pressures are applied wholesale, for example, to managers who can actually add value, this may inhibit innovation or asset managers’ commitment to launching new funds, as they see little commercial return.
There is also the issue of job security to consider. It is always going to be in an IFA’s or fund selector’s interest to go with a well-known brand, where choosing a smaller fund might leave them open to criticism.
This is not to say that all innovation is good or every start-up is worth investment.
Many fund groups are guilty of opening funds at the top of the market as a means of satiating investors’ appetite, only to have these new funds disappoint.
But without sponsorship of new funds in current market conditions we are unlikely to get the new talent and build new funds, and investors are going to be missing out on real returns.
Developing a robust and credible investment process that is capable of identifying and conducting expert analysis of smaller funds is integral to our approach at City Financial.
Without such funds, investors would have missed out on a number of valuable return streams and not now have the option of including them in their portfolios. The perfect storm for smaller fund management companies and small funds continues to rage, but smart managers will continue to welcome the right opportunities.
Mark Harris is head of multi-asset at City Financial. The views expressed here are his own.
For more information on smaller funds with strong performance records, refer to FE Trustnet’s study titled "Top funds you’ve never heard of".