Awaiting the next fund capacity crunch

Put the events of early October aside for a moment and consider the general retail investment landscape. In most areas it's been another year of healthy fund flows and decent returns.

The one piece that's arguably missing from the puzzle is a corresponding rise in funds hitting capacity limits. Despite a(nother) year of healthy equity returns and fund flows, by our count there's been just one high-profile soft closure in the last 12 months: Evenlode Income in May.

The concept of a soft closure means different things to different people, and sometimes even depends on whether you're a large or small buyer. Take a look at wealth managers' funds of choice across the major equity sectors, though, and you can see signs of excess.

Several have had similar issues before now. Man GLG Japan CoreAlpha, the consensus Japan pick according to our data, last closed in 2014 only to reopen a year later. The most widely held Asia ex-Japan fund, Stewart Investors' Asia Pacific Leaders, is still soft-closed.

Other constraints have yet to announce themselves. BlackRock European Dynamic, the most popular European equity fund selection, eased investment constraints last year due to "additional capacity", but the strategy is now significantly larger than it was at that point.

BlackRock says it's still comfortable with the size of the fund and its offshore equivalent, and adds any hypothetical capacity limit is "dynamic" (as it were) because of factors such as changing market liquidity.

At Richard Buxton's newly-monikered Merian, sales activity on two funds have been dialled back. Merian Global Equity Absolute Return, the most popular name of all 935 funds in our database, is open but no longer actively marketed. Merian's UK Smaller Companies fund, the most popular small-cap portfolio, is in the same boat. 

Again, the firm says both still have plenty of room to take in more money. But the general trend is clear. One silver lining of a trickier period for markets is that these issues can be put off for a while longer.

Cashing out or cashing in?

Who's more bearish - the typical fund selector or the typical fund manager? The latter may have a reputation for eternal bullishness, but in reality there isn't much between them at the moment.

The latest fund manager survey from BofA Merrill Lynch shows an average 5.1 per cent weighting to cash as of the start of October, "well above" the typical 4.5 per cent level seen over the past decade. 

Up-to-date numbers aren't in yet for wealth managers, but we do have figures for the start of Q3. The average cash holding in a Balanced portfolio stood at 5.2 per cent, according to our database.

But that figure masks a wide range of weightings - the graph below, which draws data from 50 different firms, indicates just how wide.

One caveat: most of these model portfolios must also take into account the cash stashed by the funds they hold. Those who buy equities and bonds directly don't have to make this calculation - and as a result, may tend to hold a couple of percentage points more cash themselves. 

It's true that some of the DFMs on the right hand side of the chart do invest directly in a number of asset classes. But that doesn't explain these differences in full. Return targets will differ, too, but by and large these portfolios do all have the same risk-rating.

Baml says managers are bearish, but "not enough to signal anything but a short-term bounce in risk assets". When it comes to DFMs, our chart suggests it'll only take one big market move to prompt some significant performance differences between those hoarding cash and those waiting to deploy it.

Banks still lagging

The decision by Axa IM to widen the scope of its financials fund (to encompass fintech) might just be a tiny canary in the coalmine for fund buyers' attitude to banks.

Goldman and Morgan Stanley may have added to the Q3 reporting cheer for the sector yesterday, but they and US peers have seen share prices slump this summer despite a healthy economy and rising interest rates. That isn't how things are supposed to work. Meanwhile the reaction in Europe to the latest Italian debt drama shows vulnerabilities on the continent haven't gone away, and the reason for the discount to UK valuations doesn't need stating here.  

So it's little surprise that few financials funds currently feature in DFMs' portfolios. Just four active funds of this ilk are found across the 300+ model portfolios we track.

Another reason for this is that there isn't much appetite for thematic funds in general. These days, exposure is often taken via mainstream portfolios. Much as buyers use Scottish Mortgage for tech exposure, they use something like Neptune European Opportunities to play a bank recovery.

That strategy hasn't worked in the short-term, clearly. And continued nervousness over banks' fortunes has also manifested itself in a different way for wealth managers: ETFs tracking financial or bank indices are as popular as active funds in our database. This is the most obvious area of growth for smart beta: sectors or regions where DFMs can make a tactical call and have the flexibility to move out quickly if things don't go right.