Why does higher capital base reduce returns?
I understand that strategies work only up to a certain level of capital, but surely large AMs can silo their teams to continue to outperform? For example, if smaller AMs ($50billion) can beat the market, surely larger AMs have $50 billion worth of potentially ‘market beating’ capital available to them?
Again, I understand strategies are different, but from what I can see a lot of the smaller and larger AMs use similar strategies.
Ah, the classic conundrum of asset management scale versus performance! Let's swing through the jungle of finance wisdom to get a grip on this:
Dilution of Alpha: When asset managers grow in size, their ability to nimbly move in and out of positions diminishes. This is because larger trades can impact the market, making it harder to execute strategies without affecting the prices of the securities they are trading.
Capacity Constraints: Many market-beating strategies have a limited capacity for capital before they start to lose their effectiveness. This is because the opportunities to exploit inefficiencies or arbitrage opportunities can only absorb a certain amount of capital before those inefficiencies are corrected by the market.
Operational Challenges: Larger asset managers might face increased complexity in managing multiple teams and strategies. While siloing teams can help, it also adds layers of management and potential communication issues that can detract from performance.
Market Impact: Larger trades by big asset managers can move the market, which can work against them. For instance, if a large asset manager tries to build a position in a smaller company, the share price may rise before the position is fully built, reducing potential returns.
Regulatory and Liquidity Constraints: Larger asset managers may also face more stringent regulatory requirements and have a harder time finding liquid opportunities to deploy large amounts of capital without affecting the market.
Now, it's not all bananas and doom for the big players. Some large asset managers do manage to outperform by leveraging their resources for better research, risk management, and by accessing a broader set of investment opportunities. However, the agility and niche focus of smaller managers can often give them an edge in beating the market.
Remember, in the jungle of asset management, size can be both a strength and a weakness. It's all about how you swing from the vines!
Sources: LBO Returns - Increasing Leverage Doesn't Increase Returns?, Leverage and success, https://www.wallstreetoasis.com/forum/hedge-fund/the-hedge-fund-experience-good-bad-ugly?customgpt=1, The Hedge Fund Experience - Good, Bad, Ugly, Venture Capital Salary versus BB and Private Equity
It has to do with market size/liquidity. If you execute a large order volume to buy a stock with a small daily trading volume, that large volume in of itself will affect the stock price. Not to mention the potential horrors of exiting out of a large position without the sufficient trading volume necessary => which may lead to the bid ask spread widening. Therefore, large AMs are limited in their universe of stocks to invest in without distorting markets. Problem is that the extremely liquid markets of large caps, indexes, treasuries, etc are extremely efficient, which makes it difficult to outperform among an entire sea of other managers chasing that same alpha.
I understand this, but surely there are still lots of available opportunities?
For example, say a $20 billion AM makes an alpha generating bond trade. A large AM could have also made this trade (albeit only up to $20 billion). Plenty of small AMs exist - how can these smaller firms find opportunities that the large AMs can’t? Or is it simply not as profitable for the large AMs to dedicate resources to finding small capital opportunities?
Yes that’s true, however the 20 MM is an insignificant amount of capital compared to the total AUM of the large AM. So if the large AM has 1B MM AUM and there’s two opportunities: one that it’s 20 MM with 20% return and another that’s 200 MM with 5% return, the 20 MM trade will return 4 MM while the 200 MM trade will return 10MM.
Ok but why not pursue multiple 20 MM trades with 20% returns? Well first of all, the diversification of trades will dilute your returns, and you end up tracking the market. Second, is that the opportunity cost/effort to hire additionally head count isn’t worth it as it’s simply much easier to search for the 5% 200 MM trades than it is to find multiple 20% 20 MM trades for a large fund to achieve the same returns.
And sure, there’s large AM managers that have small cap funds, however the AUM of those strategies make up a smaller AUM with the inability to scale up compared to large cap.
It's not that it's easier, it's that you don't have money for the extra headcount because you have to pay for the management structure of the larger firm. Your business model doesn't work if you need the same ratio of investment people to assets as a small firm. Sure there may be some savings on capital, but as I'm sure you've heard before, most of the capital at this sort of company walks out the door at the end of the day.
Assorted thoughts - Monkey and 08 have good answers.
- For some, it's simply what you talked about. You have a strategy, it works, inflows happen - other managers look to see what you are doing, duplicate as well as they can, and then the alpha dissipates as whatever edge you have goes away. Sometimes you'll have managers who find a niche and it's simply too small or esoteric - i.e. a type of bond that trades thinly or set of issuers who have idiosyncrasies to their debt profile you can exploit. Maybe it's simply a EM strategy where, well, there's all sorts of headaches including liquidity along with local market issues.
- The other reality of large AM firms, they aren't as much in the business of outperforming as they are simply managing assets to a given strategy. There is a difference there. There's entire strategies, funds, etc. that are built to be just fine - your average Core FI fund, designed for flows from whoever is distributing them, for clients who just want market + a little without wild swings. They don't want a manager who is going to go way outside the Agg, run a closet core plus fund, take big out of benchmark positions to maximize their returns. I'd take a hard look at the business models, how similar strategies are positioned, and who the clients are - this drives so much more than people realize, especially in the large AM and institutional world. Hedge Funds and similar are different animals. A $20 billion strategy, with moderate pricing power, even if it's great - only moves the needle so much to their bottom line.
- This maybe should have been said first, but it's simply hard to beat to outperform. When you do, you don't want to cap the strategy - you want inflows, you want the economics of scale to drive the bottom line, and if it waters down alpha slightly - so be it. It's part of why you see smaller AM's who solely focus on managing a specific strategy, don't get huge, and simply have allocators or other firms use them to manage specific sleeves of portfolios.
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