Does Size Matter?

By Edward A. Studzinski

By Edward Studzinski

 “Convictions are more dangerous enemies of truth than lies.”


One of the more interesting consequences of the performance of equities in 2013 is the ramp-up of the active investment management marketing machines to explain why their performance in many instances lagged that of inexpensive index funds.  This has resulted in a manure storm media blitz with terms and phrases such as “stock picker’s market” or “active share” or “concentrated portfolios.” 

“Stock picker’s market” is generally a euphemism for active management.  That is, why you should pay me 100 basis points for investing in a subset of the S&P 500, rather than pay Vanguard or some other index fund provider 5 basis points for their product.  One of the rationales I used to regularly hear to justify active management fees was that the active manager will know when to get out of the market and when to get back in, whereas the small investor will always go in and out at the wrong time.  The period of 2008-2009 puts paid to that argument when one looks at maximum drawdown numbers.  The question it raises however is whether the time horizon most investment managers and investors use is far too short.  I think it clearly is and that rather than three years or three to five years, we should be thinking of ten years at a minimum.  Unfortunately, given personnel turnover in many investment organizations, it is difficult for the investing public to know or understand that the people who gave a fund its long-term performance, looking in the rear-view mirror, are not the ones doing the analysis  or selecting the investments going forward.  And if they are, often their time and attention is pulled in many other directions.  This is why I now, sitting on an endowment investment committee, appreciate why an integral part of the investment consultant’s report covers stability of personnel and succession planning at current firms invested in as well as firms proposed for consideration.  Of course, if you are the average retail investor, you are far better off to focus on your risk tolerance, true time horizon, and asset allocation, again making use of low cost index products if you are not going to spend the time and effort to replicate the work of the consultants used by endowments and pension funds.

I am going to leave it to others to discuss “active share.”  I do think the question of “concentrated portfolios” is worth a few thoughts.  I once asked a friend of mine, at a large East Coast fund complex, how he managed to keep track of the two hundred or so stocks in his fund portfolio.  His answer was illuminating.  He said that his firm had a very large research department and prided itself on its selection and training of analysts.  Politically then, over time he had to use an idea or two from everyone or every area.  His preference would have been to have a much more concentrated portfolio.  I will refer to that then as the “ark” approach to investment management.  Other firms, such as Longleaf, have tended from the get-go to have truly concentrated portfolios , say somewhere between twenty to twenty five stocks, given that the benefits of diversification run-out at a certain number of securities.  Their rationale has been that rarely, when you are building a portfolio from the bottom up based on what are the most undervalued ideas, do ideas number thirty to forty have the same expected return potential as ideas number one to ten.  (That is even more the case with the S&P 500 hitting new all time highs now).

There is another way to look at this which I think makes it more understandable for the average person.  In 2006, Huber Capital Managed LLC performed a study, looking at value-oriented investors, entitled “Limited Assets Under Management is a Competitive Advantage.”   The study assumed an equal weighted portfolio of 2.5% positions (forty stocks) to show how the investable universe of securities shrank at certain asset levels.  It looked at the Russell 1000 Value Index and the Russell 200 Value Index.  The conclusion of the study was that as assets under management grew, portfolio managers faced increasingly unpleasant choices.  One choice of course was to shrink the investment universe, what I have referred to in the past as the rule limiting investments to securities that can be bought or sold in five days average trading volume.

 Another alternative was to increase the number of stocks held in the portfolio.  You can see whether your manager has done this by going back five or ten years and looking at annual reports.  When the fund was $5B in asset size, did it own thirty stocks?  Do you really believe that with the fund at $10B or $15B in asset size, that it has found another twenty or thirty undervalued stocks?  Look also to see if the number of research analysts has increased materially.  Are roughly the same number of analysts covering more names? 

The third choice was to make the fund very concentrated or even non-diversified by SEC standards, with individual positions greater than five per cent.  That can work, but it entails taking on career risk for the analysts and fund managers, and enterprise risk for the management company.   A fund with $10B in assets under management has available only 50% of the investable set of stocks to invest in, assuming it is going to continue to focus on liquidity of the investment as an implicit criteria.  That is why you see more and more pension funds, endowments, and family office managers shifting to low-cost index or ETF vehicles for their large cap investments.  The incremental return is not justified by the incremental fee over the low-cost vehicle.  And with a long-term time horizon, the compounding effect of that fee differential becomes truly important to returns.

My thanks to Huber Capital Manangement LLC for doing this study, and to Long Short Advisors for making me aware of it in one of their recent reports.  Both firms are to be commended for their integrity and honesty.  They are truly investment managers rather than asset gatherers. 

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.