Too Big to (Not) Fail

Illiquidity, lack of agility, and being the market: Have some funds grown dangerously large?

In 2012, an ETF appeared on the New York Stock Exchange with the ticker TRXT.

Its creators said it was “designed to be a diversified portfolio of high quality bonds that is actively managed with the aim of maximizing return and managing risk.”

Look for TRXT now and you won’t find that exchange-traded fund. Search the ticker BOND and you will. However, if you already invest in its mutual fund equivalent—the PIMCO Total Return Fund—you might find the experience smarts.

According to Morningstar, both funds have outperformed their assigned benchmark—the Barclays US Aggregate Bond Index—but BOND has had a higher net asset value and price on a total return basis than the main institutional share class of the mutual fund each quarter since it was launched.

When BOND was launched, PIMCO told investors in the ETF that they would get many of the benefits as those who allocated to the manager’s flagship fund—without the whistles and bells of derivatives—but for a lower tariff and with daily liquidity.

Today, BOND has $3.6 billion in assets. PIMCO’s Total Return has more than $225 billion. Why has the mutual fund pulled in—and mostly retained, despite investors shifting out of fixed income—so many assets when the ETF has remained relatively small, despite the undeniable shift towards passive investing?

The distressing answer: Like the adage that you’ll never get fired for hiring IBM, investors allocating to fund houses’ actively managed flagships have seldom been in trouble with their trustees or governing boards. Joining the herd of several thousand investors seems a safe bet: “If all these people think it’s good, they must be doing something right”, “They’ll put all their best ideas—and staff—into the flagship fund”, “It must have grown this big for a reason”.

But a growing number of experts have claimed the size of funds can actually work against the investors who have allocated to them—and leave them short of their investment targets.

“Some funds are so large that they effectively become the market. They make the market.”

Let’s look at the figures:  As discussed above, the world’s largest mutual fund—PIMCO’s Total Return—has more than $225 billion in assets. By the end of July, it sat at number 77 in a peer universe of 100 in a year-to-date performance ranking by Morningstar. Over a three-year period, it sat at number 43; over five, number 38. The largest US equity fund—Growth Fund of America by American Funds—has almost $140 billion in client assets. At the end of July, it sat at number 30 in a peer universe of 100 for its year-to-date performance. Over three years, it sat at number 26, and at number 61 over five years.

This trend is replicated over the largest funds domiciled and investing in mainstream asset classes around the world. Flagship these funds may be, but performance like that will not win the Americas Cup.

Their size is the main reason for this middle-of-the-road ranking rather than a lack of portfolio manager skill, experts say.

In July, a paper by UK-based academics David Blake, Tristan Caulfield, Christos Ioannidis, and Ian Tonks used a dataset of UK equity mutual fund returns and found that “fund size has a negative effect on the average fund manager’s benchmark-adjusted performance”.

Despite the largest funds often having the best managers at their helm, these flagships limp behind their smaller peers, as “the size of the fund overwhelms any superior skills they might have,” the academics said.

“The major problem for managers of large funds is that they have fewer investment opportunities,” says Detlef Glow, head of research in Europe, Middle East, and Africa (EMEA) at  data firm Lipper. “Within the UCITS [Undertakings for Collective Investment of Transferable Securities] structure, for example, there are limits on how much of one security you can own.”

Larger funds can of course make the same bets as smaller funds, but for liquidity reasons, they don’t have the same impact on performance, says Glow.

“Size helps in certain asset classes—including those that make off-market loans to large institutions—but with others it is often the smaller the better, as large funds can miss out on the more niche opportunities because they are too big,” says Steve McMillan, investment manager of the £20 billion Lloyds pension fund. “We have to think about whether a fund is too big and if its performance is going to be diluted.”

A double-digit percentage point return on a trade worth a couple of million dollars, euros, or pounds can make an impact on a fund with a couple of billion in assets. Raise that asset pool to tens or hundreds of billions and the impact is greatly reduced, meaning more opportunities need to be exploited to even keep pace with the performance of smaller peers.


(Art by Victo Ngai)

“The ability to get access to opportunities is challenging,” says Alastair Sewell, head of Fitch Rating’s fund and asset manager group in EMEA and Asia-Pacific. “You need to be able to access the inventory and not leave cash lying around. Fund managers need to ‘invest’ rather than just buy the market. This problem is acute in relatively smaller or less liquid markets such as high yield.”

However, this “investing” can cause shockwaves.

If a big fund wants to buy a security, it needs that security to come in large portions, says Glow, that buying block trades, for example, is not necessarily going to deliver alpha.

“Really large funds need a certain amount of liquidity as they are receiving inflows and seeing outflows all the time,” says Glow. “This means they have to go in the direction of the benchmark to some extent.”

Investors in large funds professing to be actively managed should take a closer look, he says.

“The majority of large active managers have a tracking error of between one and four, so they are thinly active,” says Glow (himself a former fund manager). “They should be nearer eight to ten, as they should have nothing to do with the underlying market.”

And being active isn’t just about turning over portfolios, experts say. Transaction costs eat into performance, so being active is also about taking a position against the market, which can be tricky with so many assets to allocate.

“Some funds are so large that they effectively become the market,” says Lloyds’ McMillan. “They make the market, so even if there’s a little bit of alpha, it’s not much better than just going passive. For retail investors, at least these funds offer familiarity and a kind of safety net. Being on the other side of the retail trade isn’t always a bad thing.”

It would be fair to say that professional investors have more of an idea than their retail counterparts about how large a fund should be, but they also recognise there is no sweet spot that holds true across the spectrum. A $20 billion global equities fund that doesn’t trade much and holds mainly large cap stocks would be fine, according to Oliver Kettlewell, senior research analyst at Morningstar, whereas a $20 billion small cap fund would be investing in smaller stocks and run into problems.

“Additionally, the bond universe is bigger than the stock universe so it has a broader opportunity set,” says Kettlewell. “Many large funds can make use of the whole universe from government bonds to high yield, which limits the problem. When a fund holds so much of one set of securities, it can move the market.”

This is where a fund’s strategy and approach are vital to consider. Passive funds, by their very nature, are less susceptible to capacity constraints than their actively managed peers, for example.

“People think that they should be able to move out of positions in two to three days without the rest of the market noticing,” says Ian McKinlay, director of investment at the £14 billion Aviva UK staff pension fund, who is aware of the different liquidity profiles of the various investment markets. “Many of the strategies we look at are often capacity constrained. These might be private market funds, but even in liquid markets we ask the same questions. We want to know when the money will be put to work and if we are going to see returns diluted if more assets pile in.”

In their paper, Blake et al. suggest that successful funds, which receive increasing levels of inflows, should consider splitting in order to maintain results. But with 250 funds closing a quarter in Europe, according to Fitch, this looks unlikely to happen any time soon.

Lipper’s Glow says the era of fund promoters offering seven or eight funds all with the same objective—albeit with slightly different names—is coming to an end.

“In Europe, there has been a trend of consolidation and funds are being closed, meaning there are fewer available for investors,” says Fitch’s Sewell. “This is just a pendulum swinging between rationalisation and diversification—there is every chance it will swing back.”

Fitch, Morningstar, and Lipper all keep a close eye on asset levels—and will take serious action if they think it necessary. Morningstar’s Kettlewell says his firm will downgrade a fund if its analysts think it is getting too big for the market and/or its own investment processes.

“Fund managers will identify a capacity based on markets and liquidity. They have an inherent desire to gather and manage assets but capacity limits should be managed correctly,” says Sewell. “Sometimes they soft close funds, but will also allow existing investors to allocate more. Investors should know how much could be liquidated under normal—and stressed—conditions.”

As an example: the fund manager of the Robeco US Premium Equities fund, which holds stocks across the spectrum, decided it was too big to execute trades in an optimal manner. The company soft closed it and added a 1% charge for any new investor assets. This was a sensible decision, despite it potentially hitting the company’s bottom line, says Kettlewell.

“It’s tricky to make the call and close big funds, as with an average 1.5% charge on assets they are big revenue drivers for the company,” he says. “Some asset managers are better than others at doing it.”

Investors, however, are getting wiser to the issues inherent in the largest funds on the market.

“We tend not to choose flagship funds when using comingled vehicles as we are very cognisant of the liquidity issues,” says Lloyds’ McMillan. “We might have different liquidity needs to other investors—particularly retail investors—so we instead look for a product that will closely mirror what the larger fund does.”

Some fund managers will set up a “mirror” fund on the side that effectively follows the same investment strategy as the main fund. These vehicles can also help with the package large, institutional investors are offered, McMillan says. “Many funds guarantee that no one investor gets better terms, on fees or tie in periods for example, so these replica funds avoid these issues.”

Others are wising up too.

“Consultants have become more aware about the issue,” says Aviva’s McKinlay. “Many used to just take the manager’s word for it, but it wouldn’t surprise me if they were looking more closely at it—especially as many of their own necks are on the line due to the increase in fiduciary management in the sector. Alpha suddenly becomes more precious to them in that instance.”

So are small funds the answer? Not necessarily.

“We have to make sure we are not more than 20% of any fund we invest in,” says McKinlay. “We are £14 billion and if you allocate less than 1% to 2% of your assets, you’re wasting your time. It creates a healthy tension between correct governance and making an impactful investment. For investments of £20 million to £30 million, we just don’t have the resources.”

“We are £20 billion, so 1% of our assets is the minimum allocation we would typically make,” says McMillan. “We don’t want 100 managers though, so we have to use some large funds. We can get beta exposure from these and diversify to get alpha, as finding opportunities, especially in this environment, is very important. These allocations would be no more than £500 million.”

Additionally, if funds are not big enough, they are too costly to run—hence the large number of funds being closed each quarter in Europe.

“Funds can be too small to be profitable and close—and it can be expensive to be in a fund that closes,” warns Glow. “With an ETF, all transactions are done as part of the contract with the broker-dealer. Mutual fund assets are hit by trading and legal costs.”

There are a couple of plus points for large funds: as much as positive performance is dampened, negative impacts are also lessened, and there are large opportunities across the investment universe that are just too big for smaller players.

“In general, the large funds are the flagships and promoters will do anything to make them look good, so there may also be less operational risk involved with them,” says Glow.

While you might not get fired for allocating to a flagship, you’re unlikely to get promoted either. These funds will sail into the distance unruffled, collecting their fees for making, but not troubling, the market. They leave the outperformance for someone else to find.