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Saturday, October 1, 2005
Little and large show

Investment houses sometimes refer to their size, in terms of assets managed, to prove they can do a better job. Indeed, the argument between the little and large managers can get quite heated, the one claiming superiority over the other and vice versa.
Why has this debate surfaced and who has the more convincing argument? Most bull markets (normally towards the end) are characterised by managers leaving large investment houses to set up their own ‘boutiques’. However, the inevitable bear market that follows often flushes out the opportunists from those who have sustainable businesses. The late 90’s saw a flurry of new asset managers, many who have long since disappeared and been forgotten – names such as Velocity, Prodigy, Fleming Martin and Greenwich. That said, those that have survived have both attracted assets and generally delivered very good performance for their clients. The critical issue, therefore, is the ability to identify those businesses that are likely to survive.
During the past couple of years we have again seen a new wave of managers leave established houses to set up shop on their own. Why are they leaving? And is it different this time? Managers are leaving from a desire to manage money in the manner they believe most appropriate (where they may have been constrained at a large investment house) and the potential of significant wealth. High profile and successful managers at the large houses, whilst being well remunerated, are often able to achieve significantly higher reward in running their own operations. Offshore, the explosion of hedge funds has taken this to the extreme, where reports of top “boutique” hedge fund managers earning hundreds of millions of rand in a single year are not uncommon.

Many of the smaller local managers (e.g. Polaris, RE:CM, Fraters, Prescient and Taquanta) have been very successful in attracting assets, despite the much bigger (and expensive) sales forces, marketing budgets and asset management teams of the larger houses. This has obviously begun to ruffle some feathers.
The main benefit for the smaller manager is the lower quantum of assets that allows greater flexibility, fewer constraints and a resultant larger investment opportunity set. This is particularly relevant in the SA industry, where the number of counters is limited and liquidity further constrains the universe.
The graph shows the reduction in the number of counters by which a manager can take a meaningful position (5% used as an example in this case), as the assets under management increase. For example a manager with R5 billion has 75 shares that he can purchase before owning more than 10% of the free-float), while a manger with R10 billion has a universe of 54 and a manager with R50 billion is limited to 19 counters.
It is clear that as a manager’s assets increase, he is unable to take meaningful positions in the mid-and small-cap universe without taking on greater risk, particularly liquidity risk. Such risk concerns the need to sell any of his holdings. It is precisely in this arena, which is often less researched, that mis-pricings and the potential for value-add are found.
So what is the optimum level of assets to manage? On the low side a manager requires sufficient assets to ensure that his business is profitable, and he is able to support the required infrastructure to make quality investment decisions. This varies from operation to operation (and is largely dependent on the level and type of fees), but is normally in the region of R3 billion – R5 billion.
At the top level, there seems to be a band around R10 billion – R15 billion of SA equities, beyond which the opportunity set reduces dramatically. Again, this is dependent on the style adopted by the manager. This argument does not apply to fixed interest or passive managers. Above this level, inevitably, terms like tracking error are more prevalent. At a certain higher level (R100 billion) it becomes increasingly difficult for managers to invest in portfolios markedly different from the Index. This is slightly less true of managers who have a very long-term (typically contrarian) view and who tend to be prepared to take bigger positions in less liquid counters. The main risk here is that of being forced sellers before the value identified has been unlocked, normally because of outflows after a period of under-performance.
Another contentious issue is that of business risk. Big and small businesses, by definition, have very different business risks. A small business’s primary risk is not attracting sufficient assets to survive, while a larger house’s biggest risk is probably losing existing assets and managers. This can, and does, often lead to substantially different approaches. Small managers live and die by their ability to out-perform. A mediocre small manager, with no distribution or marketing budget, will soon be relegated to the history books. The larger managers, on the other hand, are often more concerned in not under-performing their peers. This ‘looking over the shoulder’ syndrome has resulted (with a few exceptions), in most of the larger managers having remarkably similar portfolios and returns.
Although it is counter-intuitive, the key manager risk is often lower in a small house relative to a large one. This is because the key investment professional(s) usually have significant equity (and often a large percentage of their net wealth) invested in the businesses. The larger risk is that of a star manager (because there is normally one key individual) deciding to enter the Red Bull Big Wave challenge, and not quite judging his take-off correctly.
The other prickly issue is that of size of the investment team. How many investment professionals do you need to make a good decision? There is no clear answer. But considering the success of Warren Buffett, many of the world’s best hedge fund managers and some of the top managers in SA, it is evident that large investment committees are not a pre-requisite. In fact, in many cases, group-think slows decision-making, reduces individual flair and results in output that closely represents the lowest common denominator.
An ironic twist is that in response to the demand for the “alpha-generating” boutique managers, large houses have in many cases set up specialist sections and funds. In a bizarre endorsement of the advantage boutiques have, big houses have capped these funds (rather than the house) for performance reasons.
In conclusion, one encounters both good and bad large and small managers. Avoid bad small managers like the plague. An unskilled small manager is very dangerous.
But if you can find a talented ‘boutique’ manager who has: good incentives, is passionate, displays the ability to make tough decisions that are in the best interest of his clients (like capping the business), a robust investment philosophy and process, and a good track record through various cycles, then you will do well to consider entrusting some of your monies to him. By Nic Andrew, Head of Nedcor Retail Investments

Copyright © Insurance Times and Investments® Vol:18.5 1st October, 2005
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