Increasing numbers of talented fund managers, frustrated by the disadvantages of working in mainstre...
Increasing numbers of talented fund managers, frustrated by the disadvantages of working in mainstream houses, are turning to smaller boutique operations where they can exercise more creativity.
The time has come for investors to exploit the fragmentation of the fund management industry. As an increasing number of fund managers move from large to smaller investment houses, investors should follow those that have done well.
In a less structured environment that can be moulded around the fund manager's beliefs, I believe, they have every chance of doing even better.
As the majority of readers of this journal will doubtless be aware, consolidation within the fund management industry has been an ever-present theme over the course of recent years.
There are no lack of examples to quote. Invesco bought GT; the fund management arm of Lloyds TSB now includes former stand-alone businesses Scottish Widows, Abbey Life, Hill Samuel, and Lloyds Fund Managers; Aberdeen purchased Prolific and is to absorb Murray Johnstone; Prudential took over M&G.
Such a list could go on and on, even before considering the chances of an independent future for Perpetual. Anecdotal evidence, suggests the past couple of years have witnessed the consolidation of the UK fund management industry from 37 players to a dominant 17 institutions.
Economies of scale
From the point of view of the investor, however, the economies of scale reaped at the parent level are leading to unfortunate diseconomies of scale at the portfolio management level.
Scottish Widows, for example, now manages around £80bn. In order to illustrate what this sum of money represents, theoretically maintaining a 1% weighting across all their funds in the shares of Whitbread (hardly a small cap stock) would involve having to hold 35% of all Whitbread's shares.
This demonstrates that our fund management houses now run vastly larger sums of money than the capitalisation of the majority of UK-listed companies. Fund managers can consequently no longer manage their portfolios in a common sense fashion.
This is compounded by the disadvantage of operating in a large and highly structured environment in which opportunities to take quick decisions in fast moving markets are becoming increasingly difficult. All things being equal, the larger the organisation, the greater the degree of bureaucracy inherent in its structure. The end result is that many fund managers have become forced to adopt a closet index tracking approach, where the core portfolio is indexed and active fund management takes place only at the periphery.
Genuinely talented fund managers are becoming frustrated with this situation. Many privately believe they are subsidising journeymen, and the examples of successful entrepreneurs which they see in the outside world through their everyday activities, and probably backed as well, make them acutely aware of the rise of the cult of entrepreneurship within the UK.
Many individuals wish to build businesses of their own, or switch to smaller institutions where they have far more scope to exercise their creativity. It should not be forgotten that fund management is a creative business, and in this regard the successful fund manager is little different from a software developer or the founder of any other technology start-up business.
A common denominator across the industry is that fund managers often wish to run smaller amounts of money. There is a widespread belief the management of most UK investment institutions are, in contrast, volume driven. Recent statements from Standard Life and Scottish Widows bear this out, as they focus upon funds under management with no mention of profits.
Given that in reality an inverse correlation exists between size of fund and performance, the interests of individual fund managers are diametrically opposed to the interests of their masters who run these huge institutions.
It is no surprise that many wish to cap the size of funds for which they are responsible and earn a lower basic, combined with a performance-related fee, taking a share of any outperformance in a style that has been common in the US for several years.
This is in itself a good sign, since this reveals they are confident they can do well. The very fact of running a smaller portfolio means, of course, that the chance of outperformance actually occurring is that much greater.
The rewards of operating in such an environment can be potentially significant, and any investor worth their salt should be wanting to exploit their talent.
There is additionally a move away from the traditional long-only funds, such as an authorised unit trust. A common type of hedge fund is the long/short fund, where a manager can exploit situations where he believes a stock to be overvalued. These have not necessarily produced superior returns as they carry lower levels of net market exposure, and the West has enjoyed a multi-year bull market.
In sideways or falling markets, however, the benefits of this type of fund will come into sharp relief.
The listed universe is also becoming increasingly unbalanced as it bears increasingly less resemblance to the economy as a whole.
With only growth companies now being able to raise equity, an ever growing number of businesses are abandoning ship and taking themselves into private hands. Examples span companies as diverse as Linden and MEPC, where managers can now buy their company for a song due to the miserly rating applied to shares in the sector.
With private equity and venture capital gaining ground in this fashion, investors' portfolios should be taking account of this shift. Needless to say, boutiques are well placed to capitalise on this trend, as this
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