There are various examples in the investment industry of funds that show outstanding performance losing their superiority in terms of relative performance when their assets under management (AUM) increase. This effect is known as “reversion to the mean” and raises the question of whether a fund can become too big. On the other hand, we also see every quarter a number of funds liquidated because they are not profitable for the fund promoter because of their low AUM.
In this regard, it seems worthwhile to take a closer look at the AUM of a fund. AUM can impact the fund’s performance and is therefore an important topic for the fund selection process.
Small funds–in danger of liquidation
Product innovation is definitely one of the drivers of fund industry growth, but not all product ideas become successful in terms of gathering AUM. Sometimes funds struggle to attract investor money because of market circumstances or wrong timing for the launch of a product, and sometimes the trend for which the product was created is over before the product hits the market. In other cases the marketing for a good product might not be successful. Since the amount of money paid as management fees to the fund promoter depends on the AUM of the respective fund, any given fund needs to hold sufficient AUM to pay the fund promoter its dues. As I learned from my conversations with fund promoters, the minimum profitable size has gone up from 5 million euros in the late ’90s to 20-25 million euros today. Since profitability has become such an important topic after the financial crisis, especially for non-independent asset managers, any fund that is not able to gather at least 20 million euros in AUM over a reasonable time horizon might find itself under review for possible liquidation.
One effect of this focus is that fund selectors might step away from small funds, since they don’t want to invest in a fund that is likely to be closed in the near future. It is also quite unlikely that a large institution with a professional fund selection process will buy into a small fund, since the fund selectors start their due diligence only when a fund has a size that fits their investment volume.
Large funds bury the risk of mediocre performance
On the other hand, we often see funds that have superb past performance and that enjoy investors’ favour achieve huge inflows, even if their performance starts to become mediocre. This raises the question of whether a fund can become too big. Generally speaking, I don’t believe an index fund with a broad investment universe such as global equities can become too big. But, the smaller the market segment or the more specific the investment strategy, the more likely it is that the performance of a fund is affected by its AUM. This is caused by the fact that a fund manager who invests in a niche eventually may not be able to buy into his best investment ideas anymore, since the names he wants might be too small in terms of their market capitalization or their trading volume.
Since the fund manager needs to invest money within his investment universe, when the AUM in his fund is going up he starts to buy securities that fit his needs in terms of size and liquidity. This chase for liquidity normally leads to a more benchmark-oriented portfolio with a lower active share and therefore declining outperformance, the so-called reversion to the mean.
In addition, the performance of an actively managed fund is affected by the costs of the transactions to invest inflows or to generate cash to serve the redemption of fund shares, since all transaction costs are paid by the fund and not by the investor who caused the transaction. This means a fund with high turnover of investor money might show underperformance just because of its transaction costs.
In summary, the size of a fund is an important factor in the fund selection process that should be monitored very closely, since a fund that is too small carries the risk of liquidation, while a fund that is too big might not deliver the expected return. Fund selectors need to have a clear view about the size of a fund’s investment universe so they can make assumptions about the appropriate maximum size of a fund in the respective market segment.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.