Investors should keep an eye on the size of their funds, as big shifts can lead to dramatic changes to the portfolio, according to experts.
When a fund becomes popular and investors pour money into it, this can create capacity issues for the manager and limit what they can invest in.
This is especially relevant in small-cap and more specialist sectors, as a fund could become too big, in terms of assets under management (AUM), to invest in young businesses.
For example, a fund with £100m in assets could buy 10% of a £50m company, making it a 5% position in the portfolio. If this fund grows to £1bn however, the position would be 0.5%, reducing its impact on the portfolio.
Although the fund could buy more stock, at a certain point it would be unable to due to market takeover rules, which dictate that an investor must make a bid for the company if they own 30% or more of the shares.
This is one of many issues that can arise from taking in more investor cash. As such, Trustnet spoke to experts to find out other pitfalls and provide warning signs if a fund has become, or is on its way to being, too big.
The key issues
James Saunders, head of portfolio management at Tatton Investment Management, said when it comes to an increasing fund size, there are two other key factors to monitor in addition to the one above.
Firstly, are the holders too big for the assets, or can the fund meet the liquidity needs of its investors in its current form?
Saunders said: “This is probably the most serious consideration as it might mean that the fund is unable to meet redemption.”
Secondly, can the fund continue to run the same way as it has in the past, or will it have to change significantly when hit with large inflows, or outflows.
“Even if redemptions can be met, the strategy may change as a result of flows rather than investment decisions,” he said.
Smaller is better
Kate Marshall, acting head of investment analysis at Hargreaves Lansdown, said there is no one-size-fits-all approach for assessing a fund’s capacity and many different factors need to be taken into account.
“The liquidity of the fund’s underlying assets are a key factor,” she said. “Smaller companies funds typically benefit from remaining smaller in size as they don’t have the problems larger funds may have deploying capital into the market quickly.”
“A rapidly growing fund, especially one investing in a less liquid part of the market, may find it harder to invest capital quickly enough,” she added.
Tom Delic, portfolio manager at Momentum Global Investment Management, agreed and said understanding how large the fund can grow while still implementing its strategy was important for assessing its portfolio.
He said: “In general, I would view smaller as better, because a fund manager’s opportunity set falls with rising AUM, and we ideally want managers who have the widest opportunity set possible.”
Delic outlined some of the clear warning signs that he and the team look out for, including an increased number of holdings relative to its history, which can be an indicator that it has had to dilute its best ideas to fit deploy more cash effectively.
Another sign is if the companies it invests in are larger than they were previously, moving from smaller or mid-cap names into FTSE 100 stalwarts.
If the fund has continued to own the stocks that it has previously, owning too large a percentage of outstanding shares in a company is also a risk, as it can be hard to find buyers for the shares if the manager changes their mind.
If a fund group launches other strategies that contain too much crossover with existing funds, this can be a sign that the fund is struggling to maintain its current positions.
But size can be an advantage
Vanguard head of product specialism Mark Fitzgerald said fund size is often relative, but larger can sometimes be beneficial, particularly in the world of passive investing.
He said: “The S&P 500 index has a market cap of around $40tn (£29.3tn) and is very liquid, so any fund benchmarked to, or tracking this index can be a lot larger than one focused on a narrower or less liquid asset class and sector.
“Size can be an advantage as it allows for economies of scale that create lower costs for investors and thereby, better chances of investment success.”
However, he admitted that there were issues. The issue of capacity, for example, is the main reason the firm advocates for broad-based benchmarks for index investors.
“We have seen recently incidents where some thematic indexes have had to be rebalanced after strong performance triggered large inflows which overwhelmed the liquidity of the small pool of underlying securities.
“Rebalancing in response to concentration challenges exposes investors to a number of risks, not least that they often end up holding a dramatically different portfolio to the one they held before the index reconstitution,” he said.
Fitzgerald added that Vanguard will close or limit purchases to active funds if it compromises the ability of Vanguard managers to manage portfolios.
In the US, it closed the Vanguard PRIMECAP Core fund after it reached a high of $3.8bn.
Two other funds managed by PRIMECAP Management Consultancy were closed to most new accounts and additional purchases by shareholders were limited.