Consultant Corner: In Asset Management, Does Size Matter?

From aiCIO Magazine's Winter 2011 Issue: Is the focus—and sometimes obsession—on assets under management when judging and predicting performance often erroneous thinking, reflective of a lack of logic? Many consultants think so.

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The tension between the David and Goliaths—between the big and small, the establishment and the new establishment—is nothing new in any industry. In the investing world, that tension exists as asset managers fight for their fair share of clients along with the respect, recognition, trust, and status that a vast client base generates—not to mention profits. Among these firms, some commentators say asset size signals more than just a monetary number; it also speaks a great deal about the potential and ability of firms to generate performance. Evidence varies as to the veracity of these claims.

This point is highlighted in examples from the pension and asset management world. While smaller firms often tout their increasingly entrepreneurial nature—their fresh perspectives, which are relatively free from bureaucratic restraints—a recent Canadian academic paper, published in September, asserts that larger pension plans have historically outperformed their smaller peers due to asset allocation, internal management, and governance. The authors argue that pension funds increase in performance as their size grows. “First and most strikingly, we find increasing returns to scale for pension plans,” the authors conclude. “Bigger is better when it comes to pension plans. Larger plans outperform smaller plans by 43 to 50 basis points per year in terms of their net abnormal returns.”

The performance increase is partially the result of a greater preference for internal management of assets at larger plans, the authors conclude. “While delivering similar gross returns, external active management is at least [three] times more expensive than internal active management, and in alternatives it is [five] times more expensive,” they write. Large plans also outperform because of asset allocation decisions unique to them, the authors write. “We find that larger plans shift toward asset classes where scale and negotiating power matter most and obtain superior performance in these asset classes,” they assert. “Larger plans devote significantly more assets to alternatives, where costs are high and where there is substantial variation in costs across plans.” Real estate and private equity add the most value, they insist.

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In contrast, recent research from Russell Investments shows that global equities managers with less staff and fewer funds outperform larger management teams in charge of more capital. Specifically the research demonstrated that those who manage under $2 billion experienced 1.96% excess return and those who manage between $2 and $5 billion had excess returns of 1.21%. Funds managing over $5 billion had negative excess return, which increased in magnitude when funds topped $15 billion. Another study (by industry analytics provider PerTrac) revealed similarly optimistic findings for the “young Davids” of the investing world, showing that smaller hedge funds performed best in 2010, while young funds outperformed their senior counterparts. The firm indicated an array of potential reasons to explain the success of young funds, including the ability to make portfolio changes more rapidly, lower fixed costs, and new technologies that enhance efficiency.

Callan Associates’ Gregory Allen, delving into this phenomenon, explains that in contrast to claims made by firms big and small—attempting to flaunt their superior abilities—assets under management is actually a questionable criterion. “There’s a belief that smaller firms are more entrepreneurial and more willing to take risk. That translates into better performance,” Allen states, “but it’s not universally true.” Based on his research, Allen noted that there were only a couple of asset classes in which a noticeable difference between big and small emerged. The key takeaway: size does matter in capacity constrained parts of the market, such as high-yield/small-cap/emerging markets. While some managers will tell you that being small is an advantage, that claim is not true by and large in fixed-income, core, and core-plus, according to Allen. In more liquid markets, there is no advantage to being big or small.

So, is the focus—and sometimes obsession—on assets under management when judging and predicting performance often erroneous thinking, reflective of a lack of logic? Many consultants think so.

According to Jeffrey MacLean, president of consulting firm Wurts & Associates, the general clamor about smaller managers outperforming their larger counterparts and vice versa further propagates the idea that there is an easy solution that a plan sponsor or consultant can use to quickly achieve excess return. “I know it is important for investment managers to have metrics to judge performance—but we all know that when performance is good they represent it as a fair and objective measure of skill. When performance is bad, the same manager claims their approach isn’t in style.”

The reality, MacLean says, is that the merry-go-round of hiring and firing managers, often at the wrong times, is expensive to plan sponsors. To further boil down the point: While assets under management and track record offer easily tangible performance metrics, many argue it can translate to somewhat of a leap of faith. “There’s no magic pill. The conversation needs to change from performance vis-à-vis a benchmark without concern to risk to achieve performance to a conversation purely focused on risk factors, such as sensitivity to interest rates,” MacLean concludes. He adds that while the industry would benefit from analyzing the factors driving performance, most plan sponsors lack adequate resources to effectively do so, and are thus more apt to focus on tangential metrics, which are overly simplistic.

While assets under management continues to be one common criterion institutional investors use to judge future success, industry sources who seek to weaken the association between AUM and performance claim to analyze the argument from a more critical lens, citing survivor bias. The impact of assets under management—and the conclusion that smaller or larger managers outperform—is overstated because of backfill bias, according to Allen, who notes that the bias highlights misconstrued notions about active management. “If a manager with a three-year track record has been successful, that product is submitted to the database. But, if they’re not successful, they won’t be added. So, only good managers with positive data get submitted,” Allen says. Thus, younger managers with less AUM are more likely to apparently achieve stellar performance—and stellar negative performance in the same vein—due to skewed incentives, more extreme risk-taking, and nuances in reporting returns. Consequently, they are often overly represented in the sample of all-star performers, he says.

“After performance, assets under management, or AUM, is probably the most common criterion institutional investors use to narrow down a universe of investment products,” Allen wrote in a 2007 paper. It shouldn’t be, according to the consensus of consultants. In putting together a portfolio, the tenet of investing is that diversification reduces risk. While it is quite clear that investors can achieve greater return with higher risk, combining big managers and small managers is imperative to achieving diversification, says Damian Handzy, CEO of risk management firm Investor Analytics. While one might expect higher returns from smaller, younger managers—who are historically more adaptable and more willing to innovate—older, more established managers may offer greater stability. Handzy asserts that they have battled a greater number of storms, and consequently, have instituted better controls and procedures, with greater financial strength to attract talent that has seen various market environments. “Smaller firms are often run on a shoestring and are less experienced—so picking between small and large is the difference between teenagehood and middle-aged adulthood,” he says.

A key caution from consultants is to avoid overvaluing personal experience, since it is inaccurate to draw broad conclusions from just a handful of data points. The art of picking and choosing managers to oversee a portfolio is a job of balancing expected returns from selected managers with the risks they introduce or hedge in a portfolio. In short: with investing, it’s not a matter of big or small; it’s balancing the two to achieve performance.

—Paula Vasan

From aiCIO Magazine's Winter 2011 Issue: Is it the San Diego Country Employees Retirement Association's attempts at good governance, and not poor investment decisions, that are causing its problems?

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Sunshine is the best disinfectant. It also causes sunstroke. The San Diego Country Employees Retirement Association (SDCERA) probably receives more negative attention than all other Southern Californian pension funds combined—from this magazine, as well as local and national news organizations. Yet, is it the fund’s attempts at good governance, and not poor investment decisions, that are causing its problems? The composition of the fund’s board is the rule, not the exception, for American pension governance. It has one ex-officio member, four appointed members, and four members elected by pension members. According to our sources, only one of those appointed members has serious financial experience. Compared to its international or endowment equivalents, this board is non-professional and susceptible to public pressure. Yet it has adopted one central tenant of good governance—transparency.

Yes, investment employees have invited criticism that would exist regardless of this transparency. Outsourced chief investment officer Lee Partridge has garnered some vitriol from outside skeptics and internal staff—specifically, Lisa Needle, who recently departed the pension for hedge fund consultancy Albourne Partners. Another employee was recently fired after (but not because of, according to a SDCERA spokesperson) going public with accusations that the fund had breached risk budgets. Yet there is contention within most organizations. The difference between SDCERA and other public funds is its transparency, which manifests with the fund posting video of its board meetings on its website. Combine this with a relatively contentious local political environment in conservative San Diego and a board susceptible to public pressure, and you have a recipe for—well, an SDCERA-type problem.

So is transparency alone insufficient for—and potentially harmful to—good governance? According to numerous governance experts, the answer is yes. “Greater transparency which causes problems, or great transparency alone, is insufficient to have a well-functioning system,” one well-known governance guru, who wished to remain anonymous, told me. “Transparency alone doesn’t fix things.”

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“Look, the key is with the Board,” said another governance guru, also anonymously. “You need expertise and you need objectivity. With expertise, it’s about what they bring to the table, what their background and training are. You need knowledgeable people on your investment subcommittees, people with actual expertise in private and public markets. With objectivity—who do they owe their appointment to, and who has the power to remove them?” In SDCERA’s case, these sources say, the true problem lies with the board—not the levels of transparency the fund provides an interested public. With a majority of board members being non-experts, and many being voted in and taken out at the behest of a segment of the public, providing transparency is a half-measure that misses the mark and can, in fact, make the job of managing billions of dollars in retirement capital more difficult.

Perhaps it is helpful to look abroad for the appropriate counterpoint. In Canada, for example, pension funds are organized under the Crown Corporation structure, where there are several degrees of removal from the political process for pension board members. These members almost always have legal or financial backgrounds, and are appointed by individuals who themselves often have expertise in financial or legal matters. Transparency, however, is not considered the height of good governance.

Perhaps SDCERA should be applauded for attempting to improve governance in a field that has much to improve. However, if pension governance experts—and much-lauded examples such as the Canadian model—are to be believed, it has not gone nearly far enough, and is suffering because of it.

—Kip McDaniel

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