Obesity can have a strong impact on a fund's performance

When a fund's assets get too big, it may have to change its strategy or forego opportunities.

Yan Barcelo 9 August, 2017 | 5:00PM

An investment fund can become too big for its own health, and investors should be attentive to the dangers of asset obesity.

"It's a major theme, but it is not often talked about," claims William-André Nadeau, vice-president and portfolio manager at Tactex, in Quebec City. "There's been much talk in recent years about management fees, he continues, but issues concerning size constraint on a fund could be just as important."

Fund obesity manifests essentially as liquidity constraints and the market impact that transactions can carry, notes Nadeau. Take for example a portfolio manager who has $100,000 to invest in a $10 stock with a $500 million market capitalization and a daily trading volume of 50,000 shares. That manager will not be subject to any perceptible transaction constraint.

Now consider that this manager has $20 million to invest in the same stock. If he tries to invest it all at once, which means purchasing one million shares, he'll send the stock's price in the stratosphere. If he wants to remain invisible and not impact the stock's market price, he'll have to capture only a fraction of daily trade, which Nadeau pegs at a 20% maximum. That means purchasing 10,000 shares a day, at a cost of $100,000 per day; at that pace, it will take 200 days to complete the whole transaction.

That's a lot of time in the stock market. If in that time, the stock moves upward -- a likely trend created by the manager's own transactions -- the higher price will likely cancel the potential return of his strategy. That's the penalty for obesity.

Tracking obesity

Determining if a fund is obese is a delicate matter. One needs to take into account the manager's strategy and the trading frequency it entails. For example, a value strategy will prompt fewer transactions and a lower stock turnover in the portfolio than a momentum strategy. The geographical area also weighs in: constraints are much stronger in Canada than in the United States. Diversification is also a factor: a $1-billion portfolio cut up between 200 stocks will experience less constraints than if it carries only 25 stocks.

Obesity can weigh heavily on investment decisions, as spelled out by Russel Kinnel, director of manager research and editor at Morningstar. "If assets grow to the point where they put pressure on strategy, the portfolio manager can just continue and accept that the impact of trades will go up. Or, he can move up in market capitalization and lose opportunities. Or, he can build up cash, or reduce turnover. All of the above take him away from his optimal strategy, and heighten the impact and cost of trading. Or, he can close his fund to new investors."

Closing a fund is not necessarily an easy decision to make, especially when the fund firm's marketing department pushes for continued growth -- and revenue increase. Presently, 48 of 1575 unique equity funds in Canada are closed to new investors, according to Morningstar's database, reflecting Kinnel's belief that "the industry has become more enlightened on this issue."

The greatest constraint brought on by obesity, agrees Kinnel, is the loss of flexibility. The manager can be forced to ignore certain stocks, especially in the smaller cap universe. Unfortunately, "the best returns are often obtained through small-cap stocks," highlights Nadeau.

Of course, a portfolio invested mostly in large cap stocks in the U.S. will not suffer many constraints, but the same can't be said when it comes to the small cap world, observes Nadeau. "For ten small-cap stocks in my portfolio, I must be careful when I need to trade more than $100,000 in a day. Above that level, I have to collaborate with a specialized operator who has to calibrate price discrepancies and take the necessary time. If I had $20 million to invest, I'd have to forget these stocks. Yet, they're very good."

Bond funds and ETFs also have size constraints, but these play out differently. For example, "since ETFs are listed on the stock market, they can trade very quickly, but their underlying stocks aren't necessarily as liquid," points out Richard Beaulieu, vice-president and chief economist at Addenda Capital, in Montreal. When markets turn sharply, that can cause important and unexpected price spreads for ETF owners.

In the bond market investors have to deal with the moment's mood more acutely than in the stock market, depending on whether players are buying or selling. In a buyers' market, explains Beaulieu, the manager will have to face stricter liquidity constraints than if he wants to sell. This situation is aggravated by the fact that banks for a number of years now have been holding much smaller bond inventories, adds Beaulieu.

The cost of obesity

Fund obesity can eat away at performance and exert a drag that can be as high as one percentage point, and even go up to three percentage points in more extreme situations, estimates Nadeau. Kinnel has established what he calls a "bloat" index that he calculates based on the following factors: a fund's turnover ratio, its top 25 holdings, total shares held and average daily trading volume for those holdings.

On a population of 1,000 U.S. funds representing 80% of assets under management, Kinnel found that, in the small cap space, there was a 1.47-percentage-point spread on the average five-year gross return between the most bloated funds and the least bloated ones. For mid-cap stocks, the spread stood at 1.39 percentage points; for large caps, at 1.04 percentage points.

So, fund obesity can impact returns almost as much as expense ratios, and investors would be well advised to keep an eye on the obesity scale. Kinnel's bloat ratio can give a pretty precise reading of obesity, but it requires a sophisticated calculation. So, rules of thumb can come in handy to get a rough preliminary reading, keeping in mind the many factors mentioned earlier.

In Canada, Nadeau considers it a red flag when a small- and mid-cap fund with a turnover rate below 50% reaches $500 million. With a turnover rate between 50% and 100%, it should trigger at $250 million. In large cap stocks, thresholds should be set, in the first case, at $1 billion, in the second case at $500 million.

On the bond side, Beaulieu sets the trigger point at $1 billion for corporate bonds, including high-yield bonds. More crucial than total asset size, one should keep an eye on the size of underlying positions. "A $10-million block would be quite big," he says. In government issues, he doesn't really see any constraints. No funds in Canada suffer from obesity, he estimates.

In the U.S., Kinnel sets three thresholds: US$3 billion for small cap funds, US$10 billion for mid-caps and US$20 billion for large caps.

Obesity is all about lost opportunities, insists Nadeau. "If I have $20 million to invest, he says, and liquidity constraints force me to invest only $10 million in a stock that gives me a 15% return, while I have to direct another $10 million toward a stock that delivers only a 10% return, I've just lost five percentage points of gross return."

How many opportunities like this do obese fund managers have to let go, and which we never hear from? It is an issue to which investors in Canada are more exposed.

About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, writing for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.