It is generally believed that performance deteriorates as the size of assets under management increases. Most research supports that belief.
Is that painting with too broad a brush? There are always outliers. Some large pools of money can outperform for a time (although there is the eternal problem of trying to figure out whether a period under review provides any real evidence or just noise). And being small in size is not a panacea.
There is no doubt that size matters, but what is the net effect of the particular advantages and disadvantages of being large (or being small)? We are dependent on blunt size-versus-performance comparisons because organizational attributes aren’t tracked in any kind of a systematic way, so conclusions about most attributes other than size are impractical.
Pension plans
The effect of size on the performance of institutional asset owners, specifically pension plans, is the subject of a paper from CEM Benchmarking, “A Case for Scale: How the world’s largest institutional investors leverage scale to deliver real outperformance.”
The results are based upon the analysis of the plans (public and private) in CEM’s database, over five hundred in all, with assets totaling around $15 trillion. According to the paper, the largest funds outperform smaller ones, “while taking less active risk.”
Among the findings:
→ Active management produces gross value added versus passive, which increases with the size of the plan.
→ Gross value added in public markets doesn’t vary according to the size of a plan; the benefits come from lower costs due to internalization of the investment function and/or bargaining power with external managers.
→ The bulk of the gross value added comes from private market exposures.
→ Net value added in private assets is a function of scale and the degree of internalization of the investment activity.
Charts showing the gross value added, cost, and net value added illustrate the benefits of internalization in private equity and real estate. Even with a lower gross value added on internally-managed assets, the net value added is greater than that for external funds and fund-of-funds. (In fact, the net value added is negative for each of those fund structures.)
In addition to lower costs, “a second advantage that can be gained by internalizing PE and RE is the ability to exert control over the use of leverage,” instead of having those decisions in the hands of outside managers.
A webinar about the paper featured Rashay Jethalal of CEM and Bert Clark, president and CEO of Investment Management Corporation of Ontario (IMCO); it was moderated by Jim Leech, the former head of the Ontario Teachers’ Pension Plan. As you might expect given the participants (and the fact that the session was hosted by Canadian Club Toronto), many good things were said about the so-called Canadian Model of pension governance.
Millennium Management
Switching to the asset manager side of the ledger, a Financial Times newsletter included this about Israel Englander’s Millennium Management, gleaning information from the hedge fund’s most recent investor letter:
Over the past decade, Millennium’s multi-strategy fund has delivered annualised gains of 11.17 per cent a year. In the previous 10-year period — when the fund was roughly four times smaller — it returned 10.96 per cent a year. And its Sharpe ratio — a measure of return adjusting for risk — has also improved from 2.65 in the earlier period to 2.78 over the past 10 years.
This means that, as Millennium grew its asset base, returns have actually gotten better. Englander writes:
“We believe that these numbers demonstrate that, as in most industries, scale is a benefit, not a cost. While we have no intention of growing for the sake of growth, on balance, we think continued scale will lead to benefits that exceed costs.”
The FT summarized the firm in this way: “Millennium employs 278 trading teams, diversified across asset classes, investment strategies and geographies.” It is by no means the only fund organized in that fashion, but it is worth considering whether certain ways of structuring and operating a fund can allow for greater scale and still not face a decline in performance. (That said, a minor increase in Sharpe ratio over ten years yields more narrative power than statistical proof.)
Considering scale
These are two examples, regarding different kinds of organizations, where the general principle of size impeding returns is brought into question. The exercise could be extended into other parts of the ecosystem.
For instance, the growth in assets managed by OCIOs has been dramatic. That’s an aggregation strategy of sorts, but one that offers a more expensive kind of intermediation than the traditional consulting models that most OCIO clients used to use. There are obvious benefits from the new structure, but it’s unclear whether the net results are better than they would otherwise have been.
Some OCIOs have gotten very large indeed, so if there are benefits to scale, their clients should see them in terms of relative performance over time. But is that popular model the right one for smaller asset owners to use?
IMCO, mentioned above, is in the process of aggregating the assets of smaller Ontario pension plans to try to capture the advantages of scale identified by CEM. Couldn’t small foundations and endowments and other pools band together to do something similar? There are hurdles, of course, but if internalization of the investment function makes sense, why hire OCIOs (who use outside managers and charge their own fees) to do that? Wouldn’t some sort of “mutualization” make more sense?
A few questions to ponder:
Should general principles about the effect of scale be rethought?
What evidence should be used to evaluate the possibilities?
Are there structural aspects of organizations that are critical in understanding the dynamics between size and (long-term) performance? If so, what are they?
What new cooperative investment ventures for asset owners will come onto the scene in the next few years?
The Assets module of the Academy due diligence course considers issues regarding flows, scale, and capacity at asset managers.
Published: February 17, 2022
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