Jeff Bunce: Traditional active management is a wonderful business model because it scales very well. If a manager has set up shop and has all the pieces needed to run a fund, then there's little cost difference between managing $1 billion and managing $10 billion. But of course, the fees you generate on $10 billion is ten times more than for $1 billion. The rub for investors, though, is that managing ten times more money rarely yields the same results, and is often worse.
In other words, there are economies of scale for the owners of the business, but typically diseconomies of scale for fund investors. This is particularly true for investors in active equity strategies. Increased trading costs, liquidity issues, a shrinking universe of stocks to invest in are all forces that may work against a manager that's investing a larger pool of money, which may ultimately inhibit the ability to add value.
While there is general agreement that there is a finite capacity for active strategies, there is very little consensus on how to actually determine that capacity. Basically, how much is too much? Well, it will depend on a number of factors such as portfolio turnover and concentration, the size and depth of the investable universe and trading conditions in the market.
Pinning down an exact number is tough and a bit of a moving target, but there are some telltale signs that may indicate your manager is capacity-constrained. An expanding number of portfolio holdings, smaller weights in top holdings, a shift away from smaller-cap stocks, declining portfolio turnover or a downward trend in active share may all be an indication that your manager is changing the way it invests to accommodate more assets in the strategy.
Many managers recognize the pitfalls of being too big and will close their funds, or limit inflows, so that they can hopefully continue to deliver the outperformance that attracted investors in the first place. Be vigilant though, and don't assume that all managers will be proactive. After all, based on the economies of asset management, they stand to gain more than you, at least in the short term, by managing as much money as possible.
For Morningstar, I'm Jeff Bunce.
