Why smaller can be better for equity investors

When it comes to investing in a managed investment strategy -- a mutual fund, for example -- many investors do not realize that total amount of assets under management (AUM) can be an important differentiating factor in the portfolio's performance.

For example, an equity investment strategy with fewer AUM, say below $2 billion, has far more investment choices than a strategy with AUM in the tens of billions of dollars.

The reason for this situation is fairly straightforward, although it is not widely discussed in popular investment literature. 

Imagine a mutual fund which owns 50 stocks in different promising businesses, allocating 2% of the total portfolio to each company in the portfolio.

If the fund has $100 million in total assets under management, the hypothetical portfolio described above would buy $2 million worth of shares in each of the 50 different stocks. 

However, if the same hypothetical fund had $10 billion in total assets under management, the same 2% per company would now amount to $200 million worth of shares in each of the 50 different stocks.

There is a big difference between buying $2 million worth of shares in a company, and buying $200 million worth of shares in the same company. 

For one thing, placing a trade for $200 million of shares in a company will move the price of that stock much more, even if the company in question is very large with a large volume of shares traded each day.  And it will usually necessitate several days of carefully-considered trades in order to move into (or out of) that complete 2% position during which time its price can fluctuate.

But an even bigger problem for the larger fund is the fact that its sheer size will make placing 2% into many companies an impossibility, without buying the company altogether, or buying such a large share of the company that the portfolio would own 20%, 30%, or even 50% of the company (depending on the total market capitalization of the company).  

A fund with $10 billion in assets under management cannot even invest 1% in the stock of a company with a market capitalization of $100 million without buying that company completely, or in a company with a market capitalization of $200 million without buying half of the entire company. And if the fund goes up to $20 billion, then the fund cannot put 1% into a $200 million company without buying the entire thing, or into a $400 million company without ending up owning half of the entire company. 

Most investors will also understand that putting less than 1% of a portfolio into a company is not really very productive: if that company turns out to be a real winner, it won't really create very much gain if the portfolio only has 1/2 of a percent allocated to that company (hardly worth the time it takes to thoroughly research that company and to monitor its performance over time).

There are literally thousands of innovative companies with market capitalizations below $1 billion which are effectively too small for many large funds. In fact, out of the roughly 4,000 publicly-traded companies in the US listed on the major exchanges, more than 2,000 of them have market capitalizations below $1 billion, and over 2,500 have market capitalizations below $2 billion (as of 12/09/2016). 

This means that over half of the companies trading on the major exchanges will be effectively "off limits" for practical investment for a mutual fund with tens of billions of dollars in assets under management, simply by virtue of the fact that those funds are too large to be able to take a position in those smaller companies. 

To make matters worse, many of the biggest opportunities for growth will be found in companies with smaller market capitalizations. Companies that have only recently gone public, for example, may begin their careers as public companies with market capitalizations in just this capitalization range. For example, the innovative Internet-of-Things company Impinj* (ticker symbol PI) came public in July of 2016, and its current market capitalization is in the neighborhood of $600 million.

A fund with $60 billion in assets simply cannot invest even 1% in this name without buying the entire company (thereby taking them private again), while even a fund with just $15 billion in assets cannot take a 1% position of Impinj in its portfolio without owning 25% of the entire company.

However, a fund with only $1 billion in assets, or even $2 billion in assets, would have no trouble taking a position of 2% in a $600 million company like Impinj.

If you think of the job of running an investment strategy as somewhat analogous to participating in a fantasy football league, the reality described above basically means that portfolio managers of larger funds have more and more potential "players in the league" off-limits to them -- and the number of potential players who become off-limits grows as the investment portfolio gets larger. At around $2 billion and upwards (in terms of AUM), investment portfolios begin to have a harder and harder time investing in small-capitalization companies.

Note, however, that while a portfolio manager with tens of billions of assets under management cannot effectively own smaller capitalization names, a portfolio manager with fewer assets under management can still invest in BOTH larger and smaller capitalization companies without any problem. 

Investment options diminish as an investment strategy gets bigger,as does the speed with which the strategy can buy or sell an investment position. For these reasons, we believe that for some investment goals, investing in funds with fewer assets under management can offer greater opportunity.

* Disclosure: at the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Impinj (PI).