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Small is beautiful

12th August 2022

Whilst small may not be beautiful or desired in all aspects of life, for us as fund pickers it is one of the top criteria for unearthing funds with the greatest potential to deliver superior returns over the medium to long term.

We have written before about the fund management industry’s biggest conflict (see here): namely that which exists between the objectives of the investors in the funds (maximising performance), and the objectives of the shareholders of the fund management company itself (maximising revenues through maximising AUM).  There is evidence that the larger a fund, the harder it is for the fund to outperform.

Smaller funds have a key advantage over their larger peers:  their managers can establish conviction positions quickly without having to own large stakes in companies/credits that would otherwise restrict their ability to trade out of them should there be a break in thesis, or should a more attractive opportunity come along that the manager would prefer to allocate capital to. Managers of smaller funds can both buy and sell quickly without moving the price. Managers of large funds often have to chase prices higher to establish meaningful positions (higher average cost of purchase vs a smaller fund), and chase prices lower in order to sell out of positions (lower average realised sale price vs a smaller fund) which over the long term can be a big detractor to relative returns.

Crucially, for some large funds the issues highlighted above will simply preclude them from investing in many smaller companies and smaller bond issues. These are typically under-researched parts of the market where inefficiencies and the opportunities for active managers tend to be greatest. In short, smaller funds typically have a broader investible universe which, all else equal, bestows them with another important competitive advantage over their larger peers.

We like backing new and smaller funds and being key supporters in their early days because it often gives us access to cheaper, founder share classes that later investors miss out on – which gives us a further performance edge. Managers remember their early backers which means they are always happy to get on a call or meet in person to discuss their portfolio and asset class. It leads to great manager access which is important for us as we determine where in the world, and which asset classes offer the most attractive return prospects.

A lot of new and smaller funds are found at boutique asset management firms where the manager will often have a significant equity stake in the business as well as seed investment in the fund. This means they are particularly well aligned with fellow unit holders and incentivised to deliver performance, particularly in the early years of a fund’s life as they try and grow the business. Many fund buyers will not back a fund until it has reached a certain size, or until a 3 or even 5-year track record is established but often the first 3-5 years see the best performance! After this period, the fund becomes well known (if successful), more buyers come in and assets start to grow. For managers that don’t capacity constrain their funds, the danger rises that they give up the advantages a smaller fund brings. That’s the time we would be moving on.

In recent years we have backed many new, small, and nimble funds that have been excellent performers. For instance, we backed Teviot UK Smaller Companies which has risen 81% since launch in 2017, compared with its smaller company benchmark up just 8%. Gresham House UK Multi Cap Income is the best performing UK Equity Income fund since it launched in 2017 (up 57% vs IA UK Equity Income sector up 17%). R&M European is up 24% vs its benchmark the MSCI Europe ex UK up 11% since launch. Man GLG High Yield Opportunities is up 22% vs its high yield benchmark up just 3% since launch in 2019. The list goes on and we hope to meaningfully add to it in the coming years too.

Finally, it’s worth pointing out that simply buying all the new and smaller funds isn’t a free lunch. A high level of diligence is required when it comes to assessing key factors like manager credentials (are they experienced with a strong track record at a previous home – this is most desirable!), the quality of the business they work for (and type, we prefer standalone fund management companies vs insurance companies for instance), the team that support them, the systems and processes in place and the philosophy underpinning how the fund is managed – not to mention the return expectations from the asset class more broadly. If all those boxes are ticked, and the fund is small and nimble, there is a strong chance of strong performance being achieved.

Dan Cartridge – Assistant Fund Manager

For professional advisers only. This article is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC487.

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