Magazine Issues » April 2011

BURSTING AT THE SEAMS: boutiques and capacity

overweight_410Funds that performed well historically are bound to attract inflows and boutique firms need to keep a tight hold on capacity to avoid a negative impact on performance, finds Angele Spiteri Paris

A boutique asset manager’s funds need to perform. If they do not, it is similar to giving clients a dress from Primark when they were expecting a hand-sewn couture gown.

Growth, and the way it is managed within a boutique firm, is vital to preserving the returns that are so crucial to a specialist asset manager’s survival. And although fund inflows are a reason to rejoice, unfettered expansion could have a negative effect on a firm’s ability to perform.

Therefore, specialist or boutique asset managers should hold tightly onto the reins of their firm’s growth.

The term “boutique” and what it stands for has often been debated. For these purposes, a boutique is as an independent, specialised asset manager that differentiates itself through its investment philosophy and focuses on a small number of strategies.

For smaller firms, growth and expansion are obviously important goals. But such fund houses need to restrain themselves and not give in to the dangerous temptation of growing too big too soon.

Michelle Seitz, head of William Blair Investment Management, says: “When a firm gets caught up in its own growth perspective and financials, it can be to the detriment of ultimate client needs.”

Suzy Neubert, sales and marketing director at JO Hambro Capital Management (JOHCM), agrees: “Most strategies are undermined by huge asset growth.”

Asset inflows keep a fund management company afloat, but a great influx of cash can distort a fund’s performance. Therefore, that flow needs to be managed and essentially tamed.

American financial experts such as Roger M Edelen, assistant professor of management at UC Davis School of Management, and Gjergji Cici, assistant professor in economics and finance at Mason School of Business, have shown that large money inflows into funds with strong historical performance usually reduce future performance because of transaction costs and distorted trading decisions.

Boutique managers are aware of this danger and being tight with product capacity is crucial to maintaining the good performance historically generated by their funds.

Tim Warrington, head of Skagen International, a Norwegian value manager, says: “Our ambition is to provide the best possible return and this cannot happen if you have unconstrained growth in your products.”

Seitz says: “Managing growth is of critical importance in terms of protecting our business model and safeguarding alpha generation for our clients. Preserving performance is important and it becomes more difficult the larger you become.”

No need for speed
A key part of managing the growth of a specialised investment manager is the control of the inflows and outflows into products.

Warrington says that controlling the “velocity of money”, that is how fast money goes in and out of the firm, is vital to the preservation of performance. “We have a very pro-active approach to managing the velocity of money because it can impact badly on performance if we don’t monitor the subscriptions and redemptions closely,” he says.

Any large move, he says, both in inflows or outflows, can have a very significant impact on a fund’s performance. Therefore, it is essential for boutique managers to have mechanics in place to deal with potential larger-than-average subscriptions or redemptions.

“We deal with the issue of velocity of money in a proactive way and we seek to manage it for the benefit of our existing clients,” he says.

“When an institutional prospect is considering the placement of a significant sum of money, they welcome dialogue with a boutique manager on how best to bring the money into the fund. That could be over a series of tranches spread out over several weeks or even longer. We’ve done this on a number of occasions to the benefit of prospective and existing clients. That’s quite a common practice and one that has worked very well for us to manage the speed of inflows and outflows.”

Neubert, at JOHCM, says: “If we’re due to receive a larger-than-average mandate, we would discuss it with the fund manager and ask how he or she is ready to receive that money.”

She points out that the lead time between the firm being made aware of a potential inflow and the money actually coming in is enough for the managers in question to be sufficiently prepared for the inflow.

For William Blair, part of the answer to managing the velocity of money is to make the product’s capacity constraints clear from the start. Seitz says: “We have a long history of managing capacity constrained products and we’re very aware of the
amount of money we’re able to manage and still be able to generate good performance.”

Neubert says: “Every strategy has an optimal size and if you start to overload it you undermine the fund manager’s prospects of doing well. If you increase that capacity you take away some of the manager’s flexibility.”

Talking of outflows, Seitz says: “Ultimately, redemptions are best forestalled by performing well for the client; however, we have successfully navigated client flows within all our strategies.”

Fund managers also make use of a variety of financial instruments to manage the velocity of money.

Neubert says: “When fund managers receive inflows and want immediate exposure to a particular market, for example, global markets that may be closed at the time, then they will use ETFs [exchange-traded funds] to gain that exposure.”

Eric Helderlé, managing director at Carmignac Gestion, a French boutique, says: “When a lot of cash is coming into a fund, you can use derivatives, such as futures, to anticipate the targeted allocation. We had substantial inflows following the crash in 2008 and that didn’t prevent us from beating the index.”

Financial theorists support the practice of using derivatives to manage fund flows. In a paper entitled How Are Derivatives Used? Evidence from the Mutual Fund Industry, its authors Jennifer Lynch Koski, of the University of Washington, and Jeffrey Pontiff, of Boston College, say: “The opportunity to invest in derivatives may allow a fund manager to implement trades at lower cost, and to manage inflows and outflows of money to and from the fund more efficiently.”

Carmignac has been on an upward trajectory for the past few years, raking in around €16bn of inflows in 2010. But what about if things turn less rosy? What happens if investors pull out their money?

Helderlé says: “When markets are bad, fund managers expect investors will withdraw their money. Therefore, they build some cash reserves in preparation.”

Cash reserves help fund managers plug any cashflow gaps and thus maintain the fund’s performance.

When a particular product has been doing well, such as the Skagen Kon-Tiki, the William Blair International Small Cap Growth Fund or the Carmignac Patrimoine, it follows that more investors will want a piece of the action.

In these cases, an easy solution could be to simply create a new product to service that demand. But managers with a specialised focus need to be wary of falling into this trap.

The managers Funds Europe spoke to all acknowledge that churning out product is not the way to go about manoeuvring a business such as theirs.

Warrington says: “We have a very focused stable of funds and we won’t create all manner of products to raise assets. Therefore, we have finite capacity in our products. That capacity is dependent upon a range of factors and is not just a matter of absolute size.”

And Skagen is not the only firm that has kept back from flooding the market with product.

Carmignac Gestion, for example, before bringing its newest emerging market fund to the market earlier this year, the firm had not launched a new product in a very long time. Helderlé says: “Creating new products is not an ongoing process at Carmignac Gestion.”

One reason is because expanding a suite of funds means some of the specialisation may be lost along the way. Helderlé explains: “The risk in asset management is to have such a large number of products to manage that it becomes more difficult to manage growth. There are many asset managers who get so preoccupied with the number of funds they provide that they can’t concentrate on giving good service.”

Other firms also acknowledge this. Majedie Investments, a boutique based in London, states on its website: “To perform, you need to commit to running only a small number of funds over the long term, not hedge your bets by launching a blizzard of products in the hope that one might work.”

Tough decisions
Managers who decide to limit the capacity available in their funds are sometimes forced to make tough decisions.

For example, in March William Blair announced it was closing its International Small Cap Growth Fund and stopped accepting new shareholder accounts at the end of the month.

Seitz explains: “The closing of the International Small Cap Growth Fund is consistent with William Blair’s philosophy of controlling asset growth to maintain the integrity of our investment process and performance for our clients.”

JOHCM, another boutique based in London, makes its capacity constraints clear from the get-go. On its website it states: “Every time we launch a fund we predetermine, in conjunction with the fund manager, the maximum amount of money that he or she is prepared to accept as new client flows into a strategy. Once any fund reaches its predetermined limit, it is closed to new investors, giving the manager the conditions in which they can deliver and sustain outperformance and stay focused on the interests of the fund’s investors.”

JOHCM has recently closed its UK Equity Income Fund to new investors after it reached capacity. Neubert says that the firm’s Rod Marsden’s JOHCM European Fund and Mark Costar’s UK Growth Fund are also close to capacity.

However, she says: “I don’t think we’ll be closing the funds to new investors imminently. Although the strategies are close to capacity, things change and it is difficult to predict when we will close them.”

Carmignac is also facing a similar situation. Helderlé says that at some point in the future, one of its funds will have to be closed for capacity reasons. And that in the future its mid-cap fund Carmignac Emerging Discovery will have to close for capacity reasons.

“We have set the target at one billion euros as mentioned in the fund’s prospectus,” he says.

©2011 funds europe