The size of a fund is an important metric, as it can impact the manager’s ability to apply their investment philosophy.
This is particularly true for funds specialising in small-caps due to liquidity considerations. For instance, a fund that has become too big will have to take excessively large positions in small companies, creating concentration and liquidity risks.
Another risk is that the fund may have to increase its exposure to larger, more liquid businesses, which would dilute its genuine small-cap exposure. In other words, this could turn a small-cap fund into a mid-cap portfolio.
Kamal Warraich, head of equity fund research at Canaccord Genuity Wealth Management, said: “A small-cap fund’s maximum size is based on ‘capacity’, which is essentially how big a total strategy can get (strategy meaning all funds and mandates run under the same philosophy and process) before it has to abandon its current investment approach.
“Many things can impact a strategy, but the most important considerations in my opinion are: size and speed of fund inflows, breadth and depth of the investable universe and liquidity profile of the fund.”
There is, however, no magic number for how big a small-cap fund can get before its size becomes a hurdle. It depends on the average market capitalisation of underlying companies, the size of positions the manager intends to take and the breadth of the market.
Nick Wood, head of fund research at Quilter Cheviot, said: “For example, small-cap investors in the US are likely to hold much larger and more liquid companies than counterparts elsewhere simply down to the structure of that market."
While US small- and mid-caps tend to be relatively large and would, in some instances, be considered large-caps if listed elsewhere, UK and European smaller companies are much less liquid.
Rob Burgeman, investment manager at RBC Brewin Dolphin, said: “The perils for a larger fund, then, of finding themselves stuck in lobster pots – investments that they can get into but not out of – are increased.
“This can be a problem, as successful strategies attract greater flows of funds. These funds then pour into the same holdings, boosting their prices further and increasing the returns of the fund. However, when the tide turns, the fund manager can find that the only buyer of some of their larger holdings was themselves. Prices then start to fall sharply, redemptions increase, and it becomes something of a vicious circle.
“Good fund management houses will soft close and then hard close their funds to prevent them growing too large and avoid this issue.”
For UK smaller companies funds, which invest in a less liquid market, the sweet spot is under £200m, saidTom Hopkins, senior portfolio manager at BRI Wealth Management. A size range between £60m and £200m is “ideal for active, concentrated, yet liquid portfolios”.
He warned against funds exceeding £500m in assets under management as they may need to increase their exposure to large- and mid-caps.
While smaller funds are generally better in this asset class, there are risks associated with buying units in tiny funds.
Hopkins explained: “The risk of investing in a fund that’s too small is that your deal size could make you a significant shareholder within the fund, which some investors may find uncomfortable.”
While Hopkins would back a fund as small as £60m, Burgeman is wary of funds under £100m.
“A micro fund is going to struggle to generate the returns required to be financially viable for the fund management group, leaving it exposed to the prospect of being abruptly shut or merged with another strategy,” Burgeman said.
“This is okay, maybe, if a fund has just launched and there is reasonable prospect of it reaching critical mass within an acceptable period.”
Small-caps have been deeply out of favour in the UK and elsewhere in recent years. Data from the Investment Association showing that the size of small-cap equity funds has contracted from £14.5bn five years ago to £9.8bn today, as a result of both outflows and disappointing returns.
Yet, easing inflation and the potential for rate cuts this year could benefit smaller companies, which are trading at significantly lower valuations than the wider UK market.
Hopkins concluded: “As smaller companies remain undervalued, we will continue to see heightened M&A activity from overseas and private equity buyers if these valuations continue.
“For a long-term investor, the current valuation of the UK small-cap market provides an attractive buying opportunity as the market still has plenty of high-quality and exciting businesses for investors.”