Where size may be a good thing

Scale can be detrimental to active equity funds, but it can help fixed income and passive investing, says Morningstar Associates' Jeff Bunce.

Jeffrey Bunce, CFA 22 December, 2017 | 6:00PM
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Jeffrey Bunce: In my last video, I spoke about the need to monitor the size of your active equity fund because of the diseconomies of scale that typically result from managing a larger pool of money. The conversation isn't complete, however, without discussing fixed income and passive investing. In the case of the former, it isn't as clear that bigger is worse; and in the case of the latter, scale actually works in the investor's favour.

Some of the same issues affecting active equity investing affect active fixed income management. The larger the fund, the more challenging or costly trading and liquidity becomes. However, trading in fixed income is done differently. Whereas stocks mainly trade on exchanges, bonds mainly trade through a dealer network. This means relationships with trading partners is more important. Larger fixed income managers may receive preferential access to deals or receive trading priority over a manager with less assets.

Further, because a bond issuer, such as a government or corporation, tends to issue new debt more frequently than issuers of stock, the primary market is also important. A larger manager may be able to anticipate an issuer's financing needs and proactively tailor a deal or commit a certain level of financing to get favourable terms. All this is to say that there are costs as well as benefits to managing a larger asset base in fixed income, making for a much more ambiguous impact overall.

Where a larger fund size is clearly as asset, though, is in market cap-weighted passive investing. In this respect, Vanguard is the model citizen. The firm is organized as a mutual company, meaning the fundholders are effectively the owners and benefit from economies of scale in the business through lower fees. We can see this in action by looking at the Vanguard 500 Index, the firm's U.S.-based mutual fund tracking the S&P 500. Over the past ten years, the fund has grown from approximately US$100 billion to over US$380 billion. At the same time, the fund's expense ratio has declined from 0.09% to 0.04%. Increased size has been a good thing for investors. Meanwhile, performance hasn't suffered, as the fund continues to closely replicate the benchmark's returns.

In the end, you still want to be careful about your fund's size, but don't paint every asset class or strategy with the same brush. Some, like active equity strategies, warrant more attention than others.

For Morningstar, I'm Jeff Bunce.

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Jeffrey Bunce, CFA

Jeffrey Bunce, CFA  Jeffrey Bunce, CFA, is a senior investment analyst for Morningstar’s Investment Management group.

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