Is Bigger Really Better?
I know this is a dangerous way to open a dialogue, but stick with me a moment. Financial advisors and investors have long sought a method for picking fund managers that will outperform the market. Naturally this leads to some very obvious criteria like past performance, quality and reputation of the investment management firm, quality of investment process and attribution analysis and other low-hanging fruit. These factors are all straightforward and logical.
After evaluating all these factors, why is there such a profound bias to assign more capital to managers with very large assets under management? Even when the evidence is overwhelming that they don’t deserve any more capital (more on that in a minute). I suggest that some of the reasons are as follows:
- One, I am less likely to get fired for recommending a large, well-known name that underperforms than I am for recommending a small, lesser-known manager who underperforms.
- Two, everyone else is doing it so the market must be right.
- Three, my detailed analysis of the large manager’s long-term track record shows strong outperformance; therefore, past performance may assure future results.
CAIA® published a study that evaluated 3,000 long/short funds in order to analyze this issue. The managers were divided into two AUM categories “small” ($50m–$500m) and “big” (over $500m). The results of this study show that small managers outperformed their big counterparts by 254 bps over five years and 220 bps over 10 years. Interestingly, virtually all of the outperformance was due to alpha. The fund population was from the HFR database of both live and dead funds so that survivorship bias is addressed. The analysis further examined the impact of rising AUM once it crosses the $500m “threshold.” As expected, when AUM increased above the threshold, relative outperformance began to decrease.
So, why is this happening and what are the implications for manager search and selection? First, the most talented managers generally prefer to start firms rather than continuing to work at large firms. The large firms are essentially training grounds for managers and the most talented move on once their track record is established.
Second, smaller managers have the flexibility to invest in a higher weighting of off-the-run or less efficiently priced securities. Third, performance fees matter. At large firms, earnings are driven by their aggregate AUM—not their performance earnings as a percentage of their EBITDA. For small managers, EBITDA is driven by performance fees. Thus, their incentives are better aligned.
The implication of this for advisors and investors is that a careful evaluation must determine whom they hire and why. In my opinion, the entrepreneurial manager who focuses on a specialty investment idea or thesis has the best probability of future outperformance.