Smaller funds have the best chance to outperform over the longer term while large funds tend to revert to the average, according to data from Hawksmoor Investment Management.
While many investors like to look for those managers with a tried-and-tested process, those investors looking for the best outperformers should back smaller funds – and preferably boutiques – according to Hawksmoor senior fund manager Ben Conway.
“We looked at the five-year relative performance of all funds in the Investment Association sectors except for multi-manager and multi-asset funds – in other words single strategy funds across bonds and equites,” he said.
“What you see is as you increase the fund size, the probability of large outperformance materially decreases. So, in order to achieve material outperformance you necessarily have to fish in the smaller fund area.”
Relative performance of funds over 5yrs
Source: Hawksmoor Investment Management
In the above graph, the vertical y-axis measures five-year relative return of every single fund in the IA sectors relative to their own sector and the horizontal X-axis represents fund size.
“What this is showing you is [that] as you buy bigger funds the closer to average performance you get,” the portfolio manager said.
“What I am not saying, however, is that just by picking a smaller fund you will guarantee higher outperformance.
“What I am saying is you have a higher likelihood of finding a fund that can outperform.”
He added: “This is not a strong criticism of buying big funds – although I think you can easily criticise them – the point is that if you do buy a big fund do not expect big outperformance that is necessarily going to justify the active management fee.”
As such, he said the best potential returns for investors are from those funds that have less than £1bn in assets under management.
However, as the above graph shows, there are funds in this range that have the potential to underperform more dramatically and investors need to be aware of how to avoid these funds.
“It is quite often fairly easy to identify those duffers because they are undersized and their OCF [ongoing charge figure] is huge or they are in redemption mode or an afterthought or tiny remnant of a big fund house,” he said.
“What you really need to make sure is that your interests as a unit holder are aligned with that fund manager – be it a boutique or a smaller fund within a larger organisation.”
He added that this is more likely within boutique firms, who are less beholden to shareholders or parent companies and are therefore more likely to keep their funds smaller in an effort to maximise their outperformance.
It is therefore important that investors not only choose smaller funds but also those that are unlikely to become too large.
Conway said: “The better things about boutique fund managers however is that more often than not they are automatically more investor aligned.
“Big fund management companies are usually listed or are part of a big organisation where the parent is very demanding.
“If they are listed for example they are accountable to shareholders who demand earnings growth. As a fund management company the key way to do that is to grow your annual management fee revenues – i.e. grow the assets in your best performing funds.
“But at some point if you grow your assets too far the performance starts to deteriorate, so you have to be certain when you buy the fund its performance is repeatable and that you know the asset growth is going to be restricted.”
One good example of a fund that has proven it is aligned to shareholders is the £733m Prusik Asian Equity Income fund run by Tom Naughton.
The fund has been a top quartile performer in the FO Equity Asia Pacific ex Japan sector over the last three and five years, returning 97.79 per cent over the past half-decade, as the below graph shows.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
However, the fund has now soft closed, meaning that it is deterring new investor capital in the fund and Conway’s said it is the “purest” example of a fund aligning itself to investors.
“He has stopped marketing it and is deterring inflows through high initial charges because the fund has got to a size that if it grows he cannot perform as well as it can, despite the fact that the fund could comfortably be two or three times its size,” he said.
There are other examples however, with BMO Global Asset Management’s co-head of multi-manager Rob Burdett highlighting TwentyFour Dynamic Bond as an example in the bond space.
“It does tend to be a little harder for boutiques to stay small and indeed to start out in the bond market because there is more work involved in terms of man power and because of the asymmetry in terms of risk and reward,” he noted.
“Ironically the fees are usually lower and that is to do with the absolute returns being traditionally lower. So you do see fewer around and the capacity limits may be on a different scale and less clear than others.
“Having said all that there are one or two out there. TwentyFour would be a good example.”
The firm was bought by Swiss bank Vontobel in 2015 meaning it is no longer a classic boutique, but Burdett added that so far there has been no change to the investment culture.
The £1.5bn Dynamic Bond fund sits in the IA Strategic Bond sector and year-to-date is a top quartile performer, returning 9.54 per cent, as the below chart shows.
Performance of fund vs sector and benchmark over YTD
Source: FE Analytics
“It is getting up there [in terms of AUM) but we talk to the managers as the assets are growing relative to other competitors and look at their attitude to marketing and other things because there are a lot of ways to soft close these days,” Burdett said.
The other fund Burdett highlighted, this time in the alternative space, was the £978m GCP Infrastructure Investments – a London-listed closed-end vehicle.
The closed-end fund is managed by Rollo Wright and Stephen Ellis and invests in debt issued by UK infrastructure project companies. The managers target completed infrastructure projects with long-term, public sector-backed, availability-based revenues.
“It is an appropriate structure for the type of debt which is long term and has some form of protection in a rising rates and/or inflation environment as more than half the assets are backed by government cashflows,” he said.