Sizing up: Identifying bloated funds

Most DFMs won’t get very far without investing in big funds, but there will always come a point where bulky inflows start to hinder returns. Sadly, the varying strategies behind different funds, combined with shifting levels of market liquidity, can make “too big” something of a moving target.

All that said, new Morningstar research has identified a number of less-obvious ways to spot a capacity constrained fund. One of these is active share - the measurement that was all the rage just a couple of years ago.

Here, too, Morningstar says bigger isn't always better. It says a significant rise in active share could just mean, say, a small-cap manager with too many assets buying bigger companies outside their traditional universe. 

By the same token, a fall in active share may mean rising inflows have pushed a manager to seek safety in benchmark-hugging. 

In short: a change in the metric often spells trouble from a capacity perspective. 

Similarly, the research also points to a jump in the fund's number of holdings as a warning sign - given it’s unlikely a manager has "kept great ideas out of the portfolio in the past".

These strategies can be helpful - another sensible tip is to never rely on a provider's own assessment of how much money their fund can take - but the overarching problem remains: every fund is different. 

Wealth firms are well aware of the threat. As we noted last week, size has played a role in the rationale of some of those abandoning high-profile absolute return names. But given the asset tipping point is so hard to spot, it may ultimately mean it's only when a fund gets truly enormous - by UK investment industry standards, at least - that a consensus emerges among DFMs. Whether that's a healthy state of affairs or not is another matter entirely.

No more middlemen

There are plenty of reasons why this newsletter isn’t called “Fund Buyer”, one of which is that many investment managers just don't have direct responsibility for buying funds anymore. Another is that some internal research teams are turning away from collective structures in order to focus on individual stocks and bonds.

DFMs – and other multi-asset specialists – have in recent times shown a renewed appetite for directly buying securities rather than relying purely on collectives. Such tactics never went away in bespoke portfolios, of course. But they're increasingly spreading to other parts of the wealth management world too. 

It’s a trend that's most obvious when it comes to UK equities, where wealth firms feel confident relying on their own market knowledge. And it’s also a sign of the cost pressures facing the industry.

As Cornelian director Marcus Brooks notes, the firm’s practice of buying domestic stocks directly is a way to use internal expertise and spare clients “a layer of management charges” levied by third-party funds.

Direct buying can equally apply to bonds, where a slight shift away from active funds has meant more purchases of individual securities as well as ETFs and trackers.

The focus on costs isn't going anywhere, particularly with the introduction of Mifid II-compliant portfolio statements and lower returns all round this year. So you might expect more DFMs to move in this direction in future - though buying and selling individual securities can bring notable trading costs itself.

One barrier to change has been the rise of platform-based model portfolios. Rebalancing these models to account for security trading and settlement times can be difficult, and the same goes for accessing those securities on the platforms themselves.

But here too, the ground is starting to shift. Here's Gillian Hepburn of Discus, an outfit that focuses on the DFM industry:

We are starting to see some platforms address this gap in functionality, which may then increase the use of direct investments through platform models.

So the idea of going back to the future, to the stockbroker strategy of old, might just gain a few more supporters next year.

What's the alternative?

The tumult affecting risk assets, and the struggles of hedge fund strategies to provide the necessary diversification, has left wealth managers looking for positive signs from other parts of their portfolios. 

Some hopes will have been pinned on the kind of esoteric alternative strategies that have proved pretty successful for DFMs in the recent past. Sadly there are increasingly mixed signs here, too.

To avoid accusations of cherry picking, we should state that certain sectors, such as infrastructure, have continued to perform very well throughout the sell-off. But there are red, or at least amber, lights starting to flash elsewhere.

Part of the problem is that many of these portfolios have simply done too well during the good times: they're still relatively correlated with other risk assets. So it may have proved for warehousing Reit Tritax Big Box, whose shares have fallen 15 per cent (in line with the wider Reit sector) since August. Broker Numis says total returns will be harder to come by in future. 

Yield compression is a common theme: observe GCP Asset-Backed Income, representative of another popular sector among wealth managers. Stifel, which downgraded the trust to neutral yesterday, notes it  has been forced to look to new investment areas, such as energy technologies, as the hunt for returns becomes harder.

Finally, look at TwentyFour Monument Bond, the ABS strategy that's owned by numerous DFMs in our database. It's continued to calmly eke out returns this year, even as asset-backed security spreads have become more correlated with corporate bond spreads. But it's notable then that TwentyFour said yesterday it doesn't think much value has emerged from said spread widening. Caution is the watchword even in the alternatives space at the moment.