When small funds get too big

What do Perpetual, ING, JB Were and Investors Mutual, all very different fund managers, have in common? All have, or are planning to, shut off at least some of their small companies funds from new investors. And all are doing it for remarkably similar reasons.

In June, Perpetual announced it would close its Wholesale Smaller Companies Fund, available through master trusts and wraps, to new money from the end of September.

“We saw the way the flow of money into the fund was growing and we realised that if it continued at that level then it was going to be a problem at some point,” Perpetual portfolio manager Matt Williams says.

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Meanwhile, ING quietly shut its Emerging Companies Fund to new investors as of July 1. In a statement to research houses, the group said it had decided to cap the fund at an appropriate size after if had met with substantial growth in funds under management.

JB Were gave a similar signal when it closed both the retail and wholesale versions of its Emerging Leaders Funds to new investors late last year.

“We did it simply to protect existing investors. If we let the fund continue to grow, there would have been a risk to performance,” JB Were chief executive Michael Clarke says.

And Investors Mutual portfolio manager Simon Conn says the group, which is no longer adding its Australian Smaller Companies Fund to the menu of any further master trusts and wraps, will eventually close the fund to all new investors.

“We are going to close it off at some stage to protect our existing unit holders. I think you can only get so large in the small companies sector,” Conn says.

The situation has sparked a debate about how big small cap funds can get before they become overburdened and unable to maintain their performance.

On one side of the coin are groups like Perpetual, ING and JB Were, which have essentially chosen to shut their funds off at well under $1 billion to avoid any downgrade in performance.

Their theory is that, given the limited size of the small cap sector in Australia, growing any bigger would not only restrict them from trading their portfolio efficiently, but also leave them with more invested in any particular stock than they would find ideal.

On the other side are groups like Colonial First State, which claims to still be able to add value even though it is managing some $1.1 billion in its Future Leader Fund, or about three per cent of the market capitalisation of the entire small companies sector in Australia.

In the middle are analysts like Lonsec’s Anthony Pesutto who, while maintaining that each manager will have a different optimum size, believes there is an ultimate limit to how much money a small cap fund can take on.

In its latest review of Australian small cap funds, Lonsec downgraded Colonial’s Future Leader Fund from ‘recommended’ to ‘approved’, citing its size as a distinct drawback.

“We haven’t seen any conclusive data to confirm [a fund’s performance] comes down to size, however you would have to start asking whether a fund that was three per cent of the market was too big,” Pesutto says.

Perhaps an equally poignant question to ask is why some small cap funds have proved so popular that they are now having to deal with issues of size and capacity.

The answer is partly about diversification. More investors are realising that having small cap exposure in a portfolio can provide good diversification away from the small number of bigger stocks that tend to dominate the larger end of the market in Australia.

But the strong inflows into some small cap funds is mostly about performance. Perpetual’s Wholesale Small Companies fund, for instance, returned 35.2 per cent in the 12 months to the end of May 2002 to outperform the ASX/S&P Small Ordinaries index by upwards of 30 per cent.

The Small Ordinaries index itself, despite taking somewhat of a hit in the last few months, still managed to outperform both the broader market S&P/ASX 300 and large cap S&P/ASX 100 indexes by about 2.5 per cent in the year to the end of July.

There is also an intuitive expectation among many investors that smaller companies should outperform larger companies over the longer term, an expectation that investment consultants like to call the small cap effect.

The truth however is that investors’ expectations are only partly right.

A recent study released by Mercer Investment Consulting found that over the past 20 years, there was no evidence, either in Australia or globally, to suggest that small cap indices outperformed their large cap counterparts.

However, the study also found that active small cap managers have good records of significantly outperforming their respective indices over the past two decades. In most cases, the margin of outperformance has been sufficient to bring returns above those recorded by large cap managers and the benchmarks they measure themselves against.

The message from the study is clear: the small cap sector offers the opportunity to achieve significant outperformance, but only if investors buy the right stocks, or invest with the fund managers who pick them.

That could be seen as becoming increasingly difficult as some of the more renowned small cap fund managers either close their funds, or reach a point where their capacity is under a cloud.

No doubt a whole new range of fund managers will try and fill the gap left by the likes of Perpetual, ING, JB Were and perhaps others down the track.

Already BT Funds Management, after poaching Ben Griffiths and Brian Eley from ING’s small caps team, has launched a new small companies fund this year.

The fund, despite its lack of track record, was treated favourably by analysts, with research group van Eyk giving it an A rating and Lonsec saying it “provided an early opportunity for clients to gain exposure to a newly created fund with no capacity issues”.

But opportunities for investors to access the small cap market may increasingly come from a range of new smaller managers looking to make an impact in the sector.

While not willing to name names, Lonsec’s Pesutto says the research group is currently reviewing a number of managers that fit the ‘boutique’ mould and which are planning to launch small cap funds aimed at retail investors.

“Now that a lot of big name managers are closing their funds, or reaching a stage when their capacity can be questioned, there will be an opportunity for smaller boutique managers in that sector going forward,” Pesutto says.

The situation could however create a degree of doubt about the small cap sector for some investors, particularly if they are unwilling to take a risk with a fund manager they do not know in a sector where the right fund manager makes all the difference.

That would be a shame if those same investors also believe that economic conditions are about to take a turn for the better.

“The small cap market tends to be highly leveraged to expectations of economic growth. Where there is an expectation of less risk aversion in the market, that is when the small cap market has tended to outperform the large cap market,” Pesutto says.

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