Proactive Skandia keen to avoid overcapacity issues

Overcapacity is a key issue in asset management and can have a significant impact on manager selection, says James Millard, chief investment officer at Skandia Investment Group, Old Mutual’s fundhouse managing £8bn (E9.6bn).

The most recent examples of capacity constraints have been in the emerging market equity space. To avoid becoming victims of their own success, Aberdeen has recently soft closed a couple of its emerging markets funds, and First State Investments has gone down the same route by making initial charges compulsory on a number of Asia Pacific and global emerging market equity strategies. The aim of soft closing is to stall the fund size, generally allowing existing investors to top up or regularly invest, and maintain quality of returns.

Skandia’s recent resolution to replace its sub-adviser of seven years, Australian fund house First State, with Sydney-based investment boutique MIR Investment Management in running its $363m Skandia Greater China Equity fund was taken exactly to avoid fears that further asset growth could be a future constraint in sustaining performance, says Mr Millard. This decision was taken in agreement with First State, which manages £26.7bn in total assets in its Asia Pacific and GEM strategies.

“For emerging markets, and Asia in particular, there are relatively few managers with a long-term track record and those have gathered the lion’s share of flows, certainly from the European markets. These are going to have capacity problems at some point in the future,” he says.

It is important therefore to identify overcapacity issues before they occur. Performance is a lagging indicator. It is very difficult for investors to judge on the returns generated by the fund today, explains Mr Millard. In fact, what drives overcapacity is the success of the asset class and the manager delivering very good relative returns.

Typically, funds have to be almost fully invested, which means portfolio managers have to buy more shares as money flows in. Overcapacity generally leads to a style drift, as the manager is forced to hunt investments that would not otherwise meet their standards. The other alternative is to have too large a shareholding in their favoured stocks.

“The increasing number of positions in the fund is one of the key symptoms of overcapacity, as the manager is forced up the cap scale, to where the liquidity is,” says Mr Millard.

There are plenty of managers in the mid and small cap space which own more than 10 per cent of the companies’ outstanding shares. This makes it really hard for the managers to shift their portfolio to adapt it to their changing market views. The percentage of stock ownership must therefore be closely watched.

“You have got to dig a lot harder to analyse what percentage of stocks managers own. This is not displayed in any fact sheet, and there is not always much transparency about that either,” says Mr Millard.

Symptoms of overcapacity are also lower stock turnover, as the fund manager cannot transact his ideas as quickly, and higher proportion of cash in the fund. “All these constraints will probably dilute the alpha and ultimately could lead to underperformance and therefore we avoid managers showing those symptoms.”

Another related factor is how closely aligned are the interests of asset management firms’ shareholders with clients’ interests. Often fund managers are affected by the so-called ‘agency problem’. Shareholders, interested in boosting their short-term profits, seek to gather as much money as possible and often attract money at the top of the market, by carrying out aggressive advertising campaigns on the hot fund of the moment.

This can often result in very negative outcomes for the client. Also, there is a commercial risk for the firm that if the portfolio manager of that large fund takes significant bets away from the index or its peer group, he may underperform, which can lead to losing assets.

But when the fund selector can identify good quality managers, and their style lends itself to maximising alpha, then the best managers are those with a very high tracking error or high active share, he says. These are the kind of managers Skandia favours.

“Not only are we using fewer managers within our overall portfolio,” says Mr Millard, explaining that there is a risk of over-diversification in the multi-manager world. “But acting in the sub-advisory space gives us a lot of freedom. We can get the best out of fund managers and we can tailor the mandate to increase their active share. This is what we do in our Best Ideas Funds, where we have asked our underlying sub-advisers to pick only 10 stocks in each of the mandates and we manage risk at the overall level.”

James Millard, Skandia