For the past six months, I have been consulting with the Nile Capital Group, a private equity firm based in Los Angeles that provides capital and expertise to small and emerging asset managers. As part of my work with them, I engaged in a study with a former colleague, Pranay Gupta, most recently the Chief Investment Officer for Lombard Odier in Hong Kong.
Pranay and I analyzed literally millions upon millions pieces of data (manipulating more than 20 million data points in all), examining monthly returns and the growth in Assets under Management (AUM) for over 50,000 US mutual funds - current and closed. Portions of the full study can be obtained by interested consultants and institutional plan sponsors by contacting Nile directly.
For my blog readers, I can share with you some of our findings. Certain of these findings support prior research, while others are quite new - and I think illuminating.
1. Larger funds are benchmark huggers. This is certainly not news to most investors, and whether the result is due to structural reasons (the strategies are too big and their trades influence the markets) or business ones ("we've succeed, so now let's not get fired") is of little consequence. Statistically, you are likely to earn near-benchmark returns if you invest with a larger manager.
2. Small funds are the best performers. However, I must offer a caveat - they are also the worst. Thus, if you don't have the resources for, or skill in, manager selection, you need to hire someone to do it for you or should otherwise index.
3. There is a relationship between performance and a manager's ability to grow assets. This conclusion may seem obvious, but there is more to it than most know. Interestingly, the best performers are not the fastest growers - and the fastest growers are not the best performers. Factors beyond performance strongly influence a manager's business success. Also, it should be noted that once performance falls below the median, there is little distinction in asset gathering ability between funds.
- The fastest growing decile of managers have a performance rank somewhere in the middle of the second quartile. In other words, you don't have to be great to grow. Good is good enough.
- The best performing managers fall near the top of the second quartile in asset gathering ability. Again, there is more to growth success than performance. It is also true that performance has become a less important, though still positive, driver of asset growth since 2006.
4. As noted previously, the top asset gatherers (on average) are mid-second quartile performers. However, over the three years following their success, they become, in aggregate, only slightly better than a median performer.
Connecting the Dots
If you want better than index performance, you need to find the right small manager in each asset class you are considering. Assuming you select the right manager, this manager's success will result in a growth in their AUM and a diminuation of your alpha over time. You will then have to go through the selection process again. In the meantime, the manager has created a highly-valued annuity business.
The work of the plan sponsor includes helping their plans achieve a certain assumed rate of return through asset allocation and manager selection. Depending upon the plan's return assumption and the returns actually realized, the employer may have to increase the annual amount contributed on behalf of employees should returns fall short.
Today, most US defined benefit pension plans are underfunded and will either need to achieve better returns, or increase their funding amounts. With taxpayers already strapped, the pursuit of higher returns matters more than ever. Unfortunately, and as I will show in my annual long-term asset class return forecasts next month, almost all plans will fail to meet their assumed rate of returns in the coming decade (the National Association of State Retirement Administrators has reported that the average assumed rate of return for State plans is currently 7.72% - US Corporate assumptions are close, albeit slightly lower).
Thus, it becomes ever more important to find new asset vehicles to help achieve these goals. One area plan sponsors should consider is not only investing with the best small managers, but also investing in the best small managers.
Also, in the interests of full disclosure, since May 1, 2014 I have been employed by Nile Capital Group and may continue in a similar role in the future. This blog post is not a solicitation on behalf of any product, current or future, that may be offered by them. The purpose of this blog is solely to convey the findings of the Gallagher/Gupta study and to suggest a potential course of exploration for plan sponsors, whether pursued on their own or through any other party.
