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Standing at just 158 cm tall, I haven’t always seen my height as an advantage. Yet my mother would often remind me: small is beautiful, and petite is unique.
It took me many more years to fully realise the power of this motherly advice and how surprisingly accurate it is in the context of asset management.
The size paradox lies at the core of the fund management business model. Every fund aspires to expand in size (and indeed, its success fuels that growth). Initially, scale brings many benefits such as broader access to opportunities, credibility, and recognition. It’s also fundamental to the fund economics as its profits are closely tied to the volume of assets managed. However, as a fund continues to grow, it inevitably reaches a point of diminishing returns in terms of alpha generation.
The law of diminishing returns is not limited to fund management; it's a basic economic principle applicable across various contexts. Consider a farmer growing crops on a fixed plot of land. Initially, adding more units of fertiliser to the soil may significantly increase crop yields. However, there comes a stage where adding additional plant food becomes less effective, as the soil becomes saturated with nutrients. Beyond this point, adding more fertiliser may not lead to significant increases in crop yields and could even harm soil quality.
Source: Downing
When a fund reaches this juncture, its large size begins to limit investment opportunities, reduces agility, and often compels managers to 'play it safe' by adhering closely to benchmarks. Herd mentality, risk aversion, or good old FOMO (fear of missing out) may take precedence over seeking unique opportunities to beat the market. Some pragmatic reasons also come into play: both research and casual market observations suggest that, to survive as a fund manager, not underperforming your peers is in fact more important than outperforming the market.
On the contrary, smaller and newer funds adopt a different mentality. Given the undertaking to create a fund from scratch—regardless of whether it’s done within the structures of a bigger house or as a standalone endeavour—most managers decide to pursue this route out of passion for investing and the desire to express their beliefs freely. Some even go so far as to tattoo their fund's logo on their shoulder. More commonly, they may choose to invest their own personal money in the funds they manage – which is one attribute we at Fox seek in our investments. Nearly all of our portfolio holdings have 'skin in the game,' except for rare cases where managers are legally restricted from investing in their own funds.
While managers’ hunger to prove themselves and alignment alone are not enough to guarantee the success of a fund - and represent only some of the many characteristics we look for - they are important ingredients that motivate them to move away from herd mentality, push towards more differentiation and explore less-covered approaches and areas of the market. This exploration can increase the likelihood of generating alpha, as it may allow managers to uncover overlooked opportunities and pursue unique investment strategies.
Take our holding, the Zennor Japan Fund as an example. The fund was not only established with the rather niche intention of capitalising on a corporate governance revolution in Japan but is also managed in a way that maximises its structure and holdings relative to its size at any given time. From the start, its managers haven’t been shy about leveraging the fund’s small size to seize stock opportunities that wouldn’t significantly impact larger funds; the larger funds struggle to acquire enough shares without owning too significant a portion of a small business. This strategy has enabled the fund to outperform its sector average by more than 40% in just over three years since its launch, contributing to its growth from just under £8 million AUM (the majority of which was contributed by the managers themselves) to over £480 million today.
Source: Morningstar and Downing, 08.02.2021 to 15.03.2024 Past performance is not a reliable indicator of future performance.
Hopefully, this exemplifies our stance well: growth is definitely desirable - we certainly want to see funds increase their assets, as shown in the case of Zennor Japan. But there are merits to getting there early and investing in newer funds and lesser-known managers. Indeed, as the saying (and my mother’s preaching) goes, 'small is beautiful.' The trick is to identify the fund’s sweet spot*, which is precisely what we aim to do at Downing Fox.
* What is this sweet spot, you might wonder? Well, this is the part where art trumps science and, in this context, the most accurate response is 'it depends'—on a mix of factors including investment style, market-cap profile, team size, holding count, and… investment intuition. More on Fox’s approach to this exact challenge soon.
Opinions expressed represent the views of the author at the time of publication, are subject to change, and should not be interpreted as investment advice.
Important notice: This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. This content contains information that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling this content, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Capital is at risk. Past performance is not a reliable indicator of future performance.
Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
