By Miles Clyne
I better clarify the subject - I’m talking about investment strategies.
A question to consider: is it better to invest in strategies that are managing smaller or larger amounts of money? Getting to the answer requires looking at two very interesting topics: diversification and trading.
- Diversification: In the investment industry, diversification is often lauded as a means to provide safety to investors. This is achieved by owning a variety of investments, as opposed to just one or a handful. Logically, if you only own one investment and it fails, you could lose all your money. But what happens when you own too many investments? Understanding this helps us answer the “does size matter?” question.
- Trading: In all investment strategies, securities have to be bought and sold. As an investor, you want to be able to buy and sell at the current market price, which is efficient trading. If a fund manager has a very large amount of shares to trade, that trade can influence the price of that security in the market. If they buy too many, it will temporarily drive the price up. If they sell too many, it will temporarily drive the price down. Consequently, the investor ends up receiving less for securities they want to sell and having to pay more for securities they want to buy. This is known as inefficient trading.
Most investment strategies have marketing material that explains their investment process and why it is different from the thousands of other choices. Regardless of why an investment strategy is different, it can be hampered by its size. As an investment strategy grows, it is often forced to increase the number of securities it holds, simply because owning too much of one investment can cause inefficient trading, which will begin to negatively impact performance.
To counteract this, progressively more securities are added to spread out the buying as the investment strategy grows. One could argue that the strategy is becoming more diversified. I’d suggest it is likely becoming diluted. Dilution can water down the returns of what may have previously been a good strategy. Another downside of dilution is that the strategy starts to look like the market it invests in, which can increase volatility. The end result for many once successful strategies is often reduced performance, and increased risk. The irony is that as these strategies lumber though the markets, they may also be impacting the results of many other investors.
So yes, size matters.
One solution is to limit or cap the size of the investment strategy. This is done for two reasons: to avoid dilution and to retain the ability to be nimble in the market (the ability to achieve efficient trading for investors). But capping does not happen very often. The reason most firms won’t cap their strategies is that they are paid based on the volume of assets they manage, referred to as assets under management or AUM. If more and more money is rolling in, it is hard to say no to the extra revenue. Remember, the manager collects a management fee based on the AUM, not on performance.
Regardless of how wealthy you are, if you invest without awareness, you can be a victim of size. Organizations that offer large investment products won’t tell you the downside to their approach.
On our website I recently posted the two questions that every investor should ask their current or perspective financial advisory team. If you follow the simple rules we suggest you will be able to invest with much greater confidence. The beauty is that pretty much all you have to do is ask two questions and let your current or perspective advisory team(s) do the work. Then pick the team with the best results and process, not the one with the best marketing pitch.