Two-thirds of investors’ cash in the IA Sterling Corporate Bond sector is held in underperforming funds, according to the latest research from FE Trustnet.
In figures to the beginning of April, data from FE Analytics shows that £49bn is invested in third- or fourth-quartile performers over the past five years, compared with £25.6bn in first- or second-quartile performers.
Breaking the numbers down into quartiles and the figures are even more damning. The average size of fourth- and third-quartile funds stands at £1,336.85m and £1,242.11m, respectively. This falls to £833.29m for a second-quartile fund and just £468.65m for a first-quartile fund.
These figures seem to suggest that fund size is an impediment to active management.
This is emphasised by the fact that by far the two largest funds in either the first or second quartile over the five-year period – iShares Corporate Bond Index at £3.8bn and Vanguard UK Investment Grade Bond Index at £2.5bn – are tracker funds.
Removing all non-active funds from the index – including £649.7m third-quartile performer L&G Sterling Corporate Bond Index and £836m fourth-quartile performer BlackRock Corporate Bond 1 to 10 Year – skews the figures even further in favour of smaller fund sizes. Once these are taken out, there is £19.24bn in first or second quartile performers compared with £47.5bn in third or fourth quartile performers – meaning more than 71 per cent of money invested in the sector is in the latter group.
Average and total size of sector quartiles over 5yrs (ex trackers)
| Total AUM (£m) | Average AUM (£m) | Average return (%) | |
|---|---|---|---|
| Top quartile | 8904.4 | 468.65 | 34.04 |
| Second quartile | 10332.7 | 574.04 | 26.13 |
| Third quartile | 22950.3 | 1275.02 | 23.13 |
| Fourth quartile | 24564.1 | 1364.67 | 16.03 |
Source: FE Analytics
There are no funds with more than £2bn in assets under management in the first or second quartile over five years, compared with seven funds of this size in the third or fourth quartile.
Scott Spencer, an investment manager on BMO’s multi-manager team, wasn’t surprised by the appearance of a negative correlation between fund size and outperformance.
“Fund size is crucial for us,” he said. “We use something called the ‘IQ Score’ to rate funds and fund managers. This is based on 16 factors and factor 16 is actually fund size and we do think it is important that fund managers know how their approach has its limitations and in particular what way an increase in AUM could affect their approach.
“There is no magic number in mind and certainly if a fund manager takes a long-term top-down view, they can manage more money than if they are short-term stockpicking trader.
“But we do believe that all managers have a certain threshold where increasing AUM will become more problematic.”
He added: “There are a bunch of reasons why we may choose to exit a fund and size or a lack of control over capacity is one of the reasons why we have sold out in the past.
“We very much believe that funds perform better early in their lives than they do later in their lives and I think a factor behind that is size.”
It is rarer for bond funds to close their doors to new money than it is for their equity counterparts, which Spencer said may be because size is less of an issue in the former – for example, he said that the fixed income market is larger and more open and that there can be thousands of versions of a bond for each equity. However, he said the impact of fund size on performance can change in line with market conditions.
“I would argue that with the pick-up in volatility at the moment, flexibility is going to become more important, and you are going to be more flexible if you run a smaller fund than you will be if you run a larger one, depending on your style.”
Kames’s Euan McNeil, co-manager of the group’s Investment Grade Bond fund, said that while the figures above are to a certain extent skewed by a handful of large funds, his group has been trying to highlight the fact that “unwieldy funds can do investors a disservice” for the best part of seven years.
“We run relatively concentrated investment-grade funds – typically 130 to 150 bonds – that focus both on making money from traditional top-down management as well as using bottom-up drivers,” he explained.
“The simple maths of such an approach – when overlaid with typical market liquidity – means that such a pro-active bottom-up philosophy which relies on exploiting inefficiencies and anomalies between how different bonds trade is not practicable beyond funds of a certain size.”
So how can investors judge when a fund becomes too big?
Spencer said alarm bells should start to ring when there is a significant increase in the number of holdings or if the fund changes its original aim.
However, he said the key for him is to ask the manager about capacity early on in the fund’s life.
“We always judge them on their first number,” he added. “A lot of the time when you see them again and they are close to that AUM, you’d be amazed because that magic number has doubled.
“We sometimes give them flexibility because occasionally liquidity in markets does improve. But this works the other way – a lot of the time you are running a fund at a size you think is manageable and then liquidity dries up – there are lots of examples of that happening in 2007 to 2008.”