Edition: December 2015 / February 2016


Matters of size

Seems that the PIC is swinging its pendulum increasingly towards “emerging”
asset managers for alpha performance. There are two sides to this coin,
with pointers for pension funds in making selections.

In the developed world, the debate on whether investment performance is affected for better or worse by the size of the asset manager tends to be academic. Larger and smaller managers fight it out from their respective corners. Clients choose the side they prefer to believe. Past performance, efficiency of systems and service, and execution of mandates are dominant criteria.

SA, part of the “emerging” world, is different. Into the mix are added such “developmental” priorities as transformation, black economic empowerment and encouragement of entrepreneurship. These aren’t luxury options for a social shine. They’re integral to the legally-sanctioned Financial Sector Charter that embraces all asset managers. They carry force. Comply or lose.

Nowhere is this more apparent than in the 2015 annual report of the Public Investment Corporation. Asset manager for the Government Employees Pension Fund, which accounts for 89% of the PIC’s R1,8 trillion in assets under management, it accelerates the developmental processes on external asset managers’ own businesses.

They compete robustly, and enviously, for slugs of PIC appointments. In its latest report, the PIC doesn’t identify those who’ve succeeded. But it’s clear that the PIC has shifted its selection criteria. The higher that an external manager ranks in its BEE compliance, the better could be its chances of making the cut.

For instance, says the report, it must contribute to enterprise development in the asset-management sector both in listed and unlisted investments. Increasingly, it is looking to support “emerging black fund managers”. Note the “emerging” qualification, by definition separating them from the larger and more established managers that boast varying degrees of blackness.

Lukhele . . . consider asset allocation

It also implies that BEE scorecard ratings, achieved even at the higher levels by large managers, are in themselves no longer sufficient. It doesn’t suggest that they’re out of the running – they cannot be because the investing of pension-fund monies requires the capacity they bring to bear – but it does suggest that the smaller black firms are being given a leg-up. In the scramble, it wouldn’t be too surprising if some consolidation of the smaller into larger is heralded.

So take head-on the contrasting views of asset managers, one large and one small, on the pure argument of whether size matters. First up is Sihle Lukehele of Foord Asset Management, one of the larger:

Investors and financial commentators frequently differentiate between “big” and “small” asset managers. This begs the question of what defines size. Once that is answered, the question that follows is whether size really matters.

First, consider the measure of “size”. Is it assets under management? Is it the number of products or funds? Is it the number of professional team members managing the funds? Should a fund manager with a single, huge fund be classified as “big”? Equally, should a fund manager with many little funds be classified as “big”? Does characterisation as a “boutique” equate to “small”, or something else?

Industry convention is a default to “assets under management” (AUM) as a proxy for size. This seems as good or bad a measure as any. At the least, it is objectively and relatively easily ascertained and commonly understood. However, AUM is a measure of neither complexity nor scalability. It also fails to address the key issue of investment capacity.

The real question is whether size affects performance. Academic research is inconclusive. Some studies show a complete lack of any correlation between size and performance (i.e. there is no relationship between them); some show an apparently more intuitive negative correlation (i.e. that the greater a manager’s AUM, the worse its relative performance); yet others show a positive correlation (i.e. that performance improves with greater AUM).

These outcomes run the full gamut and don’t really aid an investor’s manager-selection process.

The more relevant enquiry is the question of a manager’s size relative to the investable universe. Given the equity bias of most investment-management operations, such analysis typically turns to the manager’s size relative to the “free float” of the predominant market exchange. The “free float” refers to the value of all listed companies’ shares that generally trade freely (i.e. that are not held for the long-term by institutional shareholders).

Where a fund manager has a particularly large sum of equity investments relative to the market free float, it will be more difficult to invest or disinvest at the right price at the right time. In contrast, a smaller fund manager is inherently more capable of investing or disinvesting beneficially and timelessly without undue consequences.

The share market comprises both large blue-chip companies as well as many smaller and medium-sized listed companies. A fund manager with enormous AUM relative to free float might need to acquire almost all of the available shares in a smaller-capitalisation company to make the stake meaningful, or risk the investment being so small in its portfolios that the stake becomes meaningless. A fund manager less encumbered by size can add smaller-capitalisation companies to its portfolios in meaningful size lots.

This brings us to another critical consideration. The effects of size must be viewed through the prism of asset allocation.

It is well established that in multi-asset portfolios, including notably Regulation 28-compliant prudential portfolios, much of the performance is derived from astute asset allocation. The ability to invest in asset classes beyond only shares (including cash, money markets, corporate and government bonds, commodity securities, currencies and in other jurisdictions) heavily mitigates the challenges associated with size.

Govender . . . bigger universe available

Would a smaller asset manager disagree? Delphine Govender, prominent in the Association of Black Securities & Investment Professionals, heads Perpetua Investment Managers. She puts it this way:

AUM as a collective is not the best proxy for size. The real question is AUM per mandate or strategy. A fund manager that has R400bn in AUM, with 75% in income assets and only 25% in domestic equities, is smaller in terms of utilised equity capacity against a R200bn AUM domestic equities-only manager. The multi-asset class strategy by its nature utilises a limited portion of the equity capacity of any firm.

We agree that the relevant enquiry is the manager’s size relative to the investable universe. However, we do not believe that using percentage of free float is the correct measure in the SA equities market. This is primarily because a disproportionate amount of the SA free float resides in a few large shares. In fact, 10 shares account for nearly 60% of the JSE’s All-Share Index capitalisation. Consider the chart below. We have de-segmented the Alsi into batches of 10 shares per segment, ranked by median market capitalisation per segment.

The median-market capitalisation of the smallest 87 shares is below $1bn.

Therefore, if a manager is too big in SA equities, its ability to buy meaningful stakes in at least half the market is mathematically restricted. Another way of illustrating this is to ask: Given a manager’s equities under management, how many shares can it own to at least 2% of fund? Assuming that the most a manager holds for each company is 20% of its issued capital: (see graph above).

Once a manager is bigger than R100bn in SA equities, the number of shares it can own to at least 2% of fund falls to 100. Roughly 40% of the universe would be too small. For example, the 10 largest range from PSG Konsult with a market capitalisation of R9,90bn to Blue Label with R7,76bn. Naturally, there are different permutations that could make up a fund. So opportunities exist for a large manager to buy a number of the smaller companies. But the point remains that their stakes are unlikely to be significant given the concentration of the free float.

The size issue is therefore mainly relevant for a genuinely active manager whose equity investment objective is to deliver market-beating returns over time; and who therefore will need to build a sufficiently differentiated portfolio over time to deliver differentiated returns.

This is not to be mistaken to mean that large fund managers cannot add value. They can do so mostly from the large shares. Mid and small managers have the added advantage of being able to do add value from smaller shares as well.

Ironically over the last few years, the return of the JSE’s shareholder-weighted SWIX has actually come from a few large shares. Thus the benefit of being a more nimble manager has been masked. The source of returns in terms of the size of companies which deliver these returns varies over time. So the ability for the genuinely active manager to extract returns from across the market offers greater potential. Smaller and mid-sized managers have a bigger universe from which to select. They should be sufficiently skilled to know when to use this additional fire power.