Investment Fund Size Thoughts

As much as I find myself at odds with many of the concepts of academic finance, I admire the work of finance scholars in exposing the chicanery of the investment management industry, and in no area of finance scholarship is this truer than in performance measurement of active investment fund managers.

The reality is most active fund managers underperform their passive benchmarks.  According to data service and index provider Standard and Poor’s, 82% of large-cap funds failed to better the returns of the S&P 500® index over the five-year period ending June 30, 2017.  And the small-cap space was even worse, with almost 94% of small-cap funds failing to better the S&P SmallCap 600® over the same period.

My firm is often solicited by mutual fund companies and other investment institutions (apparently it is not clear that we are active managers).  When I want to be amused, I read the marketing material of these firms and listen to the sales pitches from their representatives.

One common practice for firms is to show a level of outperformance “since inception”.  The problem, often overlooked by retail investors and financial advisers, is that a more detailed look at the performance over 3-5-year subperiods almost always shows the outperformance concentrated in the fund’s early years, when the fund happened to be much smaller.  And, of course, as a fund grows it becomes harder to find mispriced investments, as the fund is thrust into more competitive markets.  As Warren Buffett has said, “a fat wallet is the enemy of high investment returns.”  Of course, size is not the only impediment to above-average performance, but size is certainly high on the list (we’ve written a white-paper about the many institutional constraints facing investment managers, available on our website at tortugacapital.com).  Specifically, increased fund size (a) limits the investment universe and (b) creates overdiversification, both of which (all else equal) impede investment performance.

The fund industry is rapidly consolidating.  According to the Investment Company Institute, 25 fund companies control over 75% of assets in mutual funds and exchange-traded funds. The industry consolidation likely means that individual investors will find it more difficult to identity smaller, niche investment funds.  Active management does not exist in a vacuum, and the institutional environment in which it is practiced greatly influences results.

In the many years that I have followed a select group of successful money managers, I have noticed a few common traits, and the most persistent characteristic of these “super investors” is their organizations are relatively small and owner-operated.  In other words, these managers are the true entrepreneurs of the investment world, whose interests are highly aligned with interests of their investors.  Sadly, such organizations are often excluded from the “preferred” lists of investment firms kept by many brokerages.  Investors will have to educate themselves on money-manager selection and do their own research to find these investment entrepreneurs.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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