18 October 2024
The extent to which alpha has become elusive has led many investment thinkers and practitioners to ponder on many potential sources of underperformance, particularly within active investment management. Fees and performance have typically taken centre stage in client concerns, especially considering the exponential growth of passive investing. However, anecdotally, amongst many cause-and-effect relationships of performance in the South African mutual fund industry, one that seems to be relatively less discussed is the impact of fund size on fund performance. This is more instructive in the South African retail investment landscape where a lion’s share of remains invested in larger asset managers.
Having said that, the growth of boutique asset managers globally and their consistent delivery of alpha has opened a rather important discussion of size and its impact on performance. While larger asset managers have often been larger recipients of asset flows, flows to boutique investment houses have gained some traction as they tended to outperform their non-boutique peers. While some boutique funds have aggressive AUM growth aspirations, it is common investment knowledge that as fund size increases, the ability to generate consistent alpha becomes more difficult, especially in stock exchanges which are relatively smaller or whose listings are decreasing.
However, the investment adage “flows follow performance” is also instructive in this instance, notwithstanding the difference that exist between flows and size. The apparent ironic relationship between flows and performance is one that gives rise to the question: at what magnitude of a fund size will returns begin to be compromised or eroded? Ramesh and Dhume (2014), in their study, ask a similar question of: “Does a huge asset base impede performance?”. This article, therefore, seeks to weigh in and reflect on this question.
Fund size and fund returns: a contested scholarly terrain
In their essay, “How Much Does Size Erode Mutual Fund Performance? A Regression Discontinuity Approach”, Reuter and Zitzewits (2021) argue that Morningstar ratings have a significant effect on fund size, essentially confirming the mantra “flows follow performance”. This maxim is also affirmed in the work of Ramesh and Dhume (2014) who remark that retail investors typically allocate to mutual funds based on past or recent performance. Reuter and Zitzewits (2021), however, arrives on this argument after having done an empirical study on Morningstar monthly data returns of 8275 mutual funds (and 19850 share classes). In their study they found that funds with higher Morningstar ratings received high inflows.
However, their research findings suggest that fund size has a no significant or material impact on fund returns. They attempt to bolster this argument by referring to Berk and Green (2004)’s model which ruled out the causal impact of diseconomies of scale on performance persistence. The view that performance is not impacted by fund size is also held by Phillips, Pukthuanthong and Rau (2017), elaborated in their paper “Size Doesn’t Matter: Diseconomies of Scale in the Mutual Fund Industry Revisited”
Pastor, Stambough and Taylor (2015) offer an interesting view in their study which shows evidence of decreasing returns to scale but at an industry level rather than at a fund level. In contrast, Ramesh and Dhume (2014) consider fund size to be an important variable and one that affects fund returns. Their study reveals that an increase in fund inflows erodes performance of mutual funds. Their study, however, was based on mutual fund return data over five-year period between April 2007 and March 2012.
Seemingly, there is no consensus in the debate on the causal relationship between fund size and performance as some investment thinkers argue in favour while others offer counterarguments. This lack of consensus among investment scholars is confirmed by Ziphethe-Makola (2016) in her work on the relationship of between AUM and alpha in South Africa. However, in the final analysis, Ziphethe-Makola (2016) finds that the growth in AUM experienced in South Africa over the last 20 years till December 2015 has neither enhanced nor impeded returns. According to her, the size effect is irrelevant to performance.
Preliminary and anecdotal thoughts
The notion that better performing funds will tend to attract higher flows seems factual. One of the top three best-performing equity funds in South Africa has more than doubled in fund size over the last ten years, currently at a fund size greater than R20 billion and being amongst the top funds to have received the highest inflows over a trailing one year, as at end of August 2022 (Corion, 2024). The top three performing funds, over five, seven and 10 years, have received the highest inflows over the last trailing one to three years.
Regarding the impact of fund size on mutual fund performance: in the South African market context, size has a meaningful impact on fund performance. This view is informed by the shrinking size of the Johannesburg Stock Exchange (JSE), which over the last ten – fifteen years has seen its listings decrease materially. In theory, larger funds could find it difficult to generate alpha consistently as their larger AUMs may prohibit them from being able to take positions in smaller companies due to liquidity constraints and position sizing limits. This may partly explain why in the last five years, none of the larger managers/funds were among the top five performing equity and balanced funds.
Over the last trailing five, seven, and ten years (until end September 2024), the top five performing SA equity funds were all funds from boutique managers, this holds true for balanced funds as well. This reinforces the view that, in the SA domestic setting, size could and most probably does matter for fund performances. Therefore, the notion that size is irrelevant for fund performances may need to be rethought in the South African context given the average of more than 14 companies delisting each year for the last twenty years. The view that fund size does not erode performance may be helpful in the assessment of offshore funds. This is due to the view that offshore markets present more broader and wider investment opportunity sets that make liquidity and concentration relatively less of a concern.
Conclusion
This article sought to weigh in on the debate on fund size and performance, briefly reflecting on the current scholarship on the subject. In the main, the article has sought to contribute to the conversation by providing preliminary thoughts in order to encourage fund selectors and investment practitioners to think more about the relationship between fund size and alpha generation.
