The recent criticism of star fund manager Neil Woodford for having large stakes in troubled companies within a mammoth fund is an indication that size can matter for some investors.
But while bigger funds can be harder to manage, it does not necessarily follow that sub-£100m funds will necessarily perform better. This week, we have picked a small UK fund from boutique firm Unicorn Asset Management and followed the manager’s investment process.
Over three years, the £32.5m Unicorn UK Growth fund has returned 50.2 per cent versus 26 per cent for the IA UK All Companies sector, according to FE.
In the first in a new series of How To guides, we asked manager Fraser Mackersie what his keys to outperformance at a small fund have been.
What are the perks and drawbacks of managing a small fund?
Clearly a fund of this size is far more flexible and nimble than much larger funds. The Unicorn UK Growth fund follows a high-conviction, multi-cap approach and the modest size of the fund also enables some of our investments in smaller quoted companies to make meaningful contributions to performance from an early stage. As we do not hold more than 1 per cent of the issued equity of any individual stock within the portfolio of the fund we feel our current approach is highly scalable.
Has the fund always been this size?
The fund was around £6m in size when I was appointed co-manager in 2011 and is currently £32.5m so it is slowly moving in the right direction. The fund size at the start of the year was just under £20m so we’ve had stronger momentum in recent months.
Any plans to merge with another fund?
No. The fund has a good track record and a clearly defined strategy of identifying innovative companies with exposure to long- term structural growth trends. That means the fund could be significantly larger without compromising this investment approach.
AJ Bell head of fund selection
With over 1,200 funds in the IA sectors that are below £100m in size, running a small fund is more common than perhaps many would think. Some of these funds will be small in size by design as they will be capacity limited, others will be growing having recently launched while others will be shrinking.
Many managers who run a small fund will highlight the benefits of this smaller size. For some, this smaller size will enable the manager to be more nimble and flexible and responsive to market conditions which if done well could enhance performance. However, this will not suit all manager styles.
Running a small fund can also bring some challenges for managers, particularly if there is significant flow in and out of the fund from unitholders. This can result in transaction costs having a disproportionate effect on performance as managers are forced to trade the underlying portfolio.
This can have an even larger impact with small funds operating in less liquid parts of the market, with large fund flows being difficult to put to work, or large redemptions bringing challenges in actually selling holdings to meet the cash need.
Furthermore, it is highly probable that smaller funds will have higher overall costs as the benefits of economies of scale are reduced. Looking at the IA UK All Companies sector, the average OCF for funds larger than £100m is 0.76 per cent, while for funds below £100m, this average is significantly higher at 1.02 per cent.
Overall, while small funds can be an interesting place to look for ideas, it is wise to tread carefully and look at why the funds are small and whether size could be detrimental to overall performance.
What’s your investment process and how do you pick stocks?
This is a high conviction long only UK equity fund which will typically have between 40 and 50 holdings. We are generalist investors, however we have a long-standing strategy of excluding the oil and gas, mining and pharmaceutical sectors as part of our investment process.
Loss-making companies are also screened out at an early stage. These two initial steps reduce our potential investment universe significantly from over 2,500 stocks to around 800.
What’s the turnover figure?
The fund has a multi-cap mandate, however we tend to find the more attractively priced growth opportunities further down the market cap scale. The portfolio turnover ratio for the year to end of July 2017 was 20 per cent, in line with our investment horizon of three to five years.
Architas investment director
The basic building blocks of running a smaller fund versus more established funds shouldn’t be much different. A clear and well thought out investment philosophy and investment process are needed. A robust set of portfolio construction rules would also benefit.
However, a smaller fund has the benefit that all investment decisions can be made solely on their own merits, managers don’t have to be as concerned over liquidity of the underlying investments or be limited on how much they can buy because fund is just too big.
However, while it benefits stockpickers they still need to have sound portfolio construction processes and risk assessment in place as there is more to building a portfolio than just buying the 30 most favoured stocks. When running a small fund, performance should be the main consideration and with that ensuring costs are kept to a minimum is critical as any fixed costs of the fund will have a greater direct impact on the overall performance, so doing as much in house and keeping a tight lid on costs is paramount. Funds under £50m struggle because of costs.
The other consideration is the flow of money as investors are attracted to successful smaller funds it can create huge inflows relative to the size of the fund – something that happened to Unicorn with its Smaller Companies fund.
This can cause a problem for a fund investing in less liquid markets such as smaller companies as it might mean the approach to constructing a portfolio needs to change as the manager might not be able to scale up some holdings, or might not want to as valuation has changed.
The size of a fund does vary depending on the market – a large cap global equity fund can arguably be larger than a UK micro cap fund and still be considered small as it’s investable universe is much larger. However, this is less of a concern as the fund size will be a big influence on overall costs. Knowing when to cap a fund size is critical with few fund managers getting this right as too often the pressure to keep a popular fund open is too great, however some fund strategies and their success are due to the limitation of the fund size.
It is probably worth noting most funds are under £500m in size, but the high profile names tend not be.
Why should investors pick your fund in the sector instead of others?
The UK All Companies sector is highly competitive but the Unicorn UK Growth fund has a differentiated approach, aiming to identify true growth opportunities, regardless of size.
This approach provides investors with exposure to opportunities across the market cap scale and to sectors, which may command smaller weightings in more index constrained larger funds.
The software and computer services sector is a great example – the sector continues to provide a large number of exciting growth opportunities which meet our clearly defined investment criteria. As a result the average weighting of this sector in the fund since February 2011 has been over 30 per cent compared to an average weight on the FTSE All-Share Index of less than 1 per cent.
This has been one of the best-performing sectors during this period, with a total return of 230 per cent, and has made a meaningful contribution to the fund’s performance.
Mackensie has been at Unicorn since 2008 and is a member of the investment committee. He has been managing the UK Growth fund since 2011, and since 2013 co-managing the firm’s UK Income fund. Prior to Unicorn, Mackensie was at F&C Asset Management.