Funds on Friday Does your fund manager have a restricted or expanded opportunity set? 04 April 2013 Volume 715 Does Your Fund Manager Have A Restricted Or Expanded Opportunity Set? WRITTEN BY: Mark Cliff, PSG Asset Management There are a multitude of companies in which investors can buy stock around the globe. Domestic unit trust managers can choose to expand the opportunity set of companies they will invest in by utilising the flexibility bestowed on them by local legislation and buying offshore companies. If they choose to do this, they will be able to expand their opportunity sets. On the other hand, some asset management companies have very large portfolios which they are required to manage. Their opportunity sets are restricted by both the restrictions imposed by local legislation as well as the risk of overexposure to smaller companies. With which fund manager should you be investing? There are a lot of investors who choose to invest with the biggest fund managers. The guys who have often been around for a long time and who have accumulated, and continue to rake in, significant flows of cash. These are managers who are obliged to allocate their investors’ money to assets which need to grow in order to meet the needs of their investors. That’s what an asset manager gets paid to do. However, as the amount of assets under management grows, that manager’s opportunity set contracts– particularly when it comes to equities. Let’s look at two companies. Company A has been around for many years and is highly regarded in the industry for the performance they generated over the years (when the funds that they managed were significantly smaller). Let’s say that Company A – across the suite of rand-denominated funds it manages plus the institutional and pool funds it also looks after – manages R100billion of equities. Company B, on the other hand, has a suite of funds which have been around for more than a decade, but has significantly smaller assets under management. Let’s say that Company B manages R1billion of equities. 1 There are currently 165 stocks listed in the JSE All Share Index . These stocks are segmented by their size into the Top 40 (“Large Caps with a median Market Capitalization of R85 billion), “Mid-Caps” (median Market Capitalization of R15 billion) and “Small-Caps” or “Micro-Caps” (median of R3 billion or less). This is the investable universe for the average man in the street. If however we look at unit trust funds and portfolios, however, the investable universe of these can become significantly more restricted the larger they get. CISCA - the Collective Investment Schemes Control Act – generally prohibits funds from buying more than 10% of the portfolio in any one company where the market capitalization exceeds R2 billion and more than 5% of any one company where the market capitalization is less than R2 billion. In addition to these prohibitions, most fund managers – from a risk-management point of view - do not like to hold excessively high holdings in any one company – particularly the smaller companies where liquidity of stock can be a significant issue. With this in mind, let’s take a look at how a manager’s investable universe contracts as portfolio size increases. Assume for this example that the managers do not want any holding to make up more than 2% of their company’s holdings; allow themselves 10 business days entry/exit to/from the position without exceeding a third of the daily traded volume of the company and finally that they would prefer to own less than 5% of the market capitalization of the company Table 1 below shows on the bottom (X) axis, theoretical portfolio sizes in R-billions and on the left (Y) axis, the number of shares on the JSE which managers of the different portfolios can invest in based on the assumptions above. Using the assumptions above, a manager who is allocating R1billion to equities will have an opportunity set of 98 stocks from which to make his or her investment choices. At R5billion this opportunity constricts to 63 stocks, at R10billion this becomes 41 stocks and so the set becomes smaller and smaller. At R50billion the choice is down to 10 stocks, at R70billion its 7 and at R100 billion there are just the 4 biggest stocks on the JSE which meet the criteria. Illustrated differently, assume a fund manager manages R10bn in equities and wants to allocate 2% of his assets, or R200m, to a small company with a market capitalisation of R2bn. This manager would therefore own 10% of this particular company. The manager with R100bn in equities however who also wants to take a meaningful position in that company (at least 2%) would end up owning the entire thing! The larger the opportunity set a manager has, the better they can allocate capital to companies which have good prospects; to companies which are offering value and to companies which, relative to the rest of the universe, have the greatest probability of outperforming. The opposite side of this coin is that the smaller the opportunity set, the fewer are the opportunities. 1 Source i-Net Glacier Research would like to thank Mark Cliff for his contribution to this week’s Funds on Friday Qualifications: B. Soc. Sc (Politics, Economics), B. Proc, CFP. After completing his studies, Mark was a candidate attorney at Findlay & Tait. He completed his tenure as a candidate attorney and was admitted as an attorney of the High Court of South Africa. He then joined Bowman Gilfillan as an attorney from 2005 to 2011. Mark then joined Alphen Asset Management in 2005 as a new business and relationship manager during which time he completed his CFP. Mark is an investment specialist and head of communications at PSG Asset Management .