"Small is Beautiful" Peter Elston writes about the benefits of smaller fund size

It is well understood, or at least it should be, that the bigger a fund gets, the harder it is to perform well. This is borne out both in theory and in practice. Various empirical studies have revealed a direct relationship between fund size and fund performance. The theory makes sense too - bigger funds are less nimble. The law of supply and demand says that the more you want to buy of a particular thing, the more you push its price up (all else being equal).

So, as funds get to a certain size, they either have to increase the number of holdings or accept that they will pay more for purchases or receive less for sales.

The latter obviously impacts investment performance. As for increasing the number of holdings, there are studies that have found funds with more holdings generally perform worse than funds with fewer. This is less intuitive but can be understood by thinking about tracking error. Pick 300 UK stocks at random and the tracking error versus the FTSE All Share will be very low. Pick 30 and it will be high. Tracking error represents the potential for a fund to outperform or underperform its benchmark. Take fees into account and the fund with low tracking error has no chance of outperforming. The fund with higher tracking error still has scope to outperform. It’s just maths.

Now, one hears a fair amount about equity funds experiencing capacity constraints and being closed to new investors, but not so much about multi-asset funds. Search for “multi-asset fund capacity constraint” and you’ll get around 100 times fewer results than the equity fund equivalent. Why is this?

I suspect it is because large actively-managed multi-asset funds don’t think too much about being high conviction or about focussing on more interesting smaller companies or less liquid bonds. Perhaps also because some large actively-managed multi-assets funds may have been able to add value from active tactical asset allocation rather than selection (this option is one that is not available to single asset class funds). Either way, it may essentially be because investors are simply not aware that capacity constraints should affect multi-asset funds just as much as equity funds.

They should be.

While it is true that asset allocation is not subject to the same constraints as stock or bond selection, a smaller multi-asset fund that is not constrained by either has, by definition, more scope to perform well.

Which of course brings me to our Seneca multi-asset funds. When it comes to managing money, we at Seneca believe in proper active management. This means being high conviction and highly active, the only way we think we can deliver alpha net of fees to our clients. Our funds focus on mid-caps in the UK as well as on some interesting specialist investment trusts. And we operate a very active asset allocation approach. And the good news is that we are some way from hitting capacity constraints.

Important Information

Please note this communication is aimed at professional advisers only. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice or a recommendation to invest in the asset referred to in this communication. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. There is no guarantee that the investment will achieve the target dividend or target total NAV returns. Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at 10th Floor, Horton House, Exchange Flags, Liverpool, L2 3YL FP18 248