The Goldilocks scenario: What is the optimum size of a fund?

Written by Danielle Levy · 14.10.20

Danielle is a freelance financial journalist and editor, with more than 14 years’ experience writing about personal finance and investments. She is also a keen baker and traveller.

Significant sums of money tend to follow the talented few in the world of investing. For example, six of the UK’s largest funds attracted close to 21% of total net flows during August, equating to £353 million, according to data provider Morningstar. Fund managers can quickly find themselves managing multi-billion pound funds once they have shown they can deliver superior performance and beat their rivals. But is big necessarily best?

It is important to look at the size of any fund you are considering investing in: whether it is big or small. For context, the average size of a UK-domiciled fund was £127 million at the end of August, according to Morningstar. If a fund is large (£5 billion plus) and everyone is talking about it, this may indicate that you have come a little late to the party. That isn’t to say the fund won’t deliver satisfactory performance, but you may have missed out on some stellar returns that were achieved earlier in the fund’s life.

Investing in a young and small fund (£50 million or lower) on the other hand, may provide you with an opportunity to get in early. However, it also brings a host of other challenges to the table. These include higher costs, as well as the risk that the fund is closed or merged later down the line if it doesn’t achieve scale. Whilst past performance is not a promise of returns in the future, a newer, smaller fund without much of a track record still has much to prove.

So how should you think about size when you are looking at funds to invest in? Below is a checklist to help you to get a better idea of what to consider.

What does the fund invest in?

Funds have a pre-defined investment universe, set of objectives, philosophy and process. If an equity fund invests across different market capitalisations or predominantly in large companies (also called large caps), its size shouldn’t necessarily stop it from meeting its objectives. However, size can pose a challenge if a fund invests in smaller companies (also called small caps) or less liquid asset classes. For example, a popular small cap fund which has ballooned in size may no longer be able to buy the same kind of assets that it used to because its average holding size has become too big. The size of the fund can therefore impact the opportunity set for new ideas and/or it can encourage the fund manager to stray into larger companies (known as ‘style drift’). Neither of these outcomes is usually good and worth keeping an eye on, as the last thing you want is for performance to be compromised because of the size of the fund.

Liquidity is key

If a fund has grown significantly in size, it will no longer be as nimble as it used to be. In financial markets this relates to how easily a fund manager can buy or sell investments without having an impact on the price. Some assets are typically very liquid, such as large caps, so even big funds can usually trade in and out without impacting the price. But if the fund invests in small caps, micro caps (defined as having a market cap of less than £150 million), or assets that aren’t even listed on a stock exchange, then liquidity can be a real challenge if a fund has grown too much in size.

What is the fund manager’s track record?

If you are considering a fairly new fund where a track record is yet to be established, it may be a good idea to consider the track record of the fund manager(s) before you write it off. For example, have they run other funds with a similar style? Have they got experience of investing through different market conditions? There is certainly something to be said for experience, particularly when a manager has invested in both bull and bear markets. So even if the fund is new, you may find that the manager brings a lot of experience to the table.

What are the costs?

Costs play an important part in your total return so it is important to consider the fees before investing in a fund. Larger funds benefit from scale, which means that the cost can be lower in comparison to smaller funds. This doesn’t necessarily mean it’s a bad idea to invest in a small fund, it may actually give you exposure to some really interesting assets compared to a large fund, precisely because of the constraints we discussed earlier. But it is important to understand what the costs are and whether they are worth taking on. Alternatively, you may find that a larger, cheaper fund is more suitable.

The Goldilocks scenario

So, what is the optimum size of a fund? Perhaps the answer lies in the beloved fairy tale ‘Goldilocks and the Three Bears’: it makes sense to approach the extremes on either side with caution. If you invest in a £20 billion fund, be prepared that the manager will have less flexibility in what they can hold compared to someone who is running £20 million. Smaller funds give you an opportunity to tap into the earlier stages of a manager’s performance and can provide access to potentially more interesting markets and companies. However, with greater opportunity comes additional risks.

The size of a fund won’t necessarily be the key determinant of returns, but it could serve as an indicator for where the fund is in its lifecycle and what constraints it might be facing. Performance goes through cycles, but the philosophy and process of a fund should remain the same. So what you want to be sure of is the consistency of the style and approach and that any past success won’t become a hindrance in the future.

The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.

When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.

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