In many industries, economies of scale help to deliver cheaper and better products. But is bigger better when it comes to delivering investment outcomes?
In most industries, there are a few multinationals that dwarf the competition. Examples range from the Big Four accounting firms, the Big Pharma, the Big Oil to FAANG1. These global goliaths have emerged mainly due to their ability to take advantage of the economies of scale, which enable them to stay ahead of competition.
In the UK, the five largest investment consultants cover 90% of the institutional Defined Benefit market. The investment management market is also highly concentrated. More than half of the global institutional money is managed by the 15 largest investment management firms2.
But is bigger better when it comes to investment outcomes?
Empirical evidence: small can be beautiful
There has been plenty of empirical research on the impact of fund size on mutual fund performance. Chen et al. (2004)3 found that fund returns (both before and after fees) decline with fund size and could partially be explained by organisational diseconomies as well as capacity constraint in investment strategies. Recent research by Harvey and Liu (2017)4 also documented a significant decreasing returns to scale, after correcting for some of the biases mentioned in previous academic literature. Hedge funds are no different.
It is the dominant risks that drive outcomes
Standard management theory recommends performance evaluation tools such as Key Performance Indicators (KPI), balance score card in combination with streamlining and automation to improve products and services. In most industries, there is a strong positive relationship between investment in process and realised gains in productivity and quality. Several processes in investment management benefit greatly from economies of scale: operations, compliance, branding, sales, client reporting and technology, to mention a few.
The economies of scale certainly have a positive impact on costs, but the size of this gain is dominated by the impact of investment returns. Investment returns are the result of making decisions under uncertainty. However, given the uncertain nature of the financial markets it is very difficult to separate manager skill from luck. Doubling the headcount of an investment team does not automatically lead to better investment performance. If the investment team grows too big, the organisation might face diseconomies of scale due to hierarchical decision structures and internal bureaucracy.
Despite knowing that the largely unpredictable investment risks clearly dominate the financial outcomes, we tend to spend most of our time and resources managing minor risks that are predictable. Peter Drucker captured this human fallacy: “Management is doing things right; leadership is doing the right things.”
When return hunters become asset gatherers
The business model of an investment firm is typically also impacted by the size of assets under management. A small investment firm is essentially a return hunter and their ability to deliver attractive investment outcomes will ultimately make or break the firm. Owners and partners of small investment firms face a risk-return profile on their private wealth similar to a private equity investment. The future value of the firm will mainly be determined by delivering superior investment performance.
Typically, as an investment firm grows in assets under management, it slowly morphs into an asset gatherer as the pound value of the annual management fee increases. Management turns its focus on growing and protecting the asset base, instead of aiming for superior investment performance. As a consequence, the investment firm will be able to deliver a stable stream of dividends to its owners.
Small funds, big opportunities
Knowing that economies of scale is not the key to robust investment outcomes, what could DB schemes do? Minor and predictable risks could be delegated to free up the trustee meeting agenda, which will help focusing on how to best manage the dominant and uncertain investment risks.
This requires working with consultants and fiduciary managers that focus on the quality of decision making under uncertainty and can engage in more robust conversations rather than following the herd. This would provide DB schemes with greater access to adaptive portfolio construction and investment strategies from specialised, and often small, investment managers.
At the end of the day, size is not the decisive factor for success. The ability to make informed decisions under uncertainty is.
1 Facebook, Amazon, Apple, Nexflix and Google
2 The Financial Times (https://www.ft.com/content/d8a58038-9a09-11e7-a652-cde3f882dd7b), The Investment Association (https://www.theinvestmentassociation.org/assets/files/research/2016/20160929-amsfullreport.pdf)
3 Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization (Chen, Hong, Huang, and Kubik, 2004
4 Decreasing Returns to Scale, Fund Flows, and Performance (Harvey and Liu, 2017)