Does size impact alpha generation?

April 4, 2014
Matthew Pouncett, CA (SA), Analyst at Laurium Capital

Glacier Funds on Friday

With the advent of passive ETF’s and other low cost investment alternatives in recent years, fund managers need to prove their Alpha generating abilities and fund of fund managers are under more pressure to select top performing managers.The list of factors to consider when selecting a fund manager or fund for investment are relatively obvious - performance, risk, fees, experience and reputation of the investment team and investment style and philosophy are typically the boxes to tick through – but what about the simple measure of size as measured by assets under management?Is size a key advantage to alpha generation or an obstacle?Larger asset managers are most certainly advantaged in terms of available resources, both in terms of human and information capital and very small managers may find it difficult to gain access to company Management and quality sell side research.

Although such factors are highly supportive of Alpha generation, once a certain fund size is reached, the level of access to Management and research are relatively similar between funds.Furthermore, with size and scale comes both the inability to move in and out of trades quickly as well as limitations as to the universe of investable securities. Based on Alexander Forbes’ January 2014 SA Equity Manager Watch survey the 10 largest Equity funds (i.e. funds with the FTSE All Share Index or a similar variation thereof as their benchmark) as ranked per assets under management had in aggregate R268bn in assets.

In contrast, the FTSE/JSE Small Cap Index has a total market capitalisation of only R260bn. 7of the top 10 largest equity funds in South Africa have assets under management above R20bnThe limitation of size is more prevalent in South African markets due to the top heaviness of the JSE, both in terms of market cap and average daily trading volumes as displayed in Figure 1. The top 5 largest shares on the JSE top 40 (ranked by 3 month average daily trading volumes) comprise 43% and 36% of the average daily trading volumes of the Top 40 and all share indices, respectively. The most liquid share, Naspers has more than double the average daily trading volumes at R2.4bn than the second placed MTN with R966m.

To attempt to quantify the impact of size on the ability of a large fund manager to build up a meaningful position in a stock, the following exercise was performed. Assuming a target position of 3% of the fund, a limitation of not being more than 33% of the 3 month average daily trading volumes on any one day and assuming a limit of 30 trading days to build up the position, Figure 2 shows that the number of “investable” securities outside the Top 40 universe diminishes dramatically with the increase in fund size. In fact, Funds greater than R10bn would only be able to build a position in one small cap stock, namely Sibanye Gold.On average, it would take an R20bn fund 499 days and 124 days to build up a 3% position in small cap and mid cap stocks, respectively. On a market cap weighted average, it would take the fund 374 days and 93 days to build up a 3% position in small and mid cap stocks, respectively. Certain stocks with extremely low liquidity such as Clientele life have been excluded from this exercise.

Given the solid performance of the Top 40, would it have been necessary to invest in mid and small cap stocks? Over the long term, the small and mid-cap indices have outperformed the Top 40 index – see Figure 3.

Furthermore, Figure 4 shows the top 10 performing stocks over the last 5 years. As can be seen 7 out of the 10 best performing shares were small caps.

Although smaller funds can have exposure to smaller cap stocks doesn’t necessarily mean they have taken advantage of the opportunity. Smaller Funds which are benchmarked against the All Share Index may not deviate to far from the Top 40 constituents given their large weightings in the index.Thus the most important factor in terms of fund size is the limit it places on manoeuvrability and the ability to act speedily in response to both market inefficiencies and news. Having a high conviction idea or view is one thing, but been able to act on that conviction in response to a market development, without moving the market, is critical to performance.

Furthermore, as the recent drop in Pinnacle Holdings share price shows, being able to exit quickly from a position is just as important.The problem of size and the ability to build up meaningful positions is even worse when investing in the rest of Africa. The top heaviness in African markets is akin to that of the JSE with the top 10 African stocks by market cap accounting for 34% of the top 200. In terms of liquidity, the lop-sidedness is more severe, the top 10 most liquid stocks (as measured by three month average daily trading volumes) account for 40% of the 200 most liquid stocks in Africa.Interestingly enough the top 10 most liquid stocks in the rest of Africa are all listed in Egypt, thus explaining the growing involvement of South African funds on the Egyptian stock exchange as managers hunt the African continent searching for liquidity. The exercise in terms of available securities, assuming a 30 day trading time limit, was conducted for African markets with the results presented in Figure 5.

Furthermore, of the 102 stocks in which a $100m dollar fund could invest, over half are listed in Egypt, hampering the funds ability to achieve country diversification – a key necessity in African investing. Figure 6 displays the very low level of country diversification that could be achieved, assuming an equal holding in each security.

However, coming back to the original question of size as a key consideration - large asset managers can and do generate alpha.However given liquidity constraints, larger funds are far more dependent on strategic over and under weightings in their smaller investable populations, find it more difficult to offer meaningful exposure to shares outside the Top 40 and cannot react as quickly to market developments.Given that smaller funds are more reactive and in the context of the South African market can offer greater exposure outside the Top 40 heavy weights and in terms of the rest of Africa, offer far greater country diversification, size is most certainly a key factor when selecting a fund manager.

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