Weekly Digest

Bigger than the Roman Empire

Lorenzo La Posta

11 December 2018

It is common belief that bigger is better, but at Momentum we do not always endorse that.

One of our functions is to choose which managers to trust our clients’ capital with: manager selection is not a scientific process, there is not a unique set of rules to “evaluate them all” and parameters to analyse are countless. Among these, we consider size (be it of the strategy, the investment team or the firm) to be a meaningful factor.

At the peak of its power in 117 AD, the Roman Empire had grown to encompass an area of over 5 million square kilometres, included more than 20% of the world’s entire population with territories comprised of what today are 48 states ranging from England to Egypt and from Portugal to Iraq. However, such a vast, diverse and widespread territory was hard to control, not to mention managing problems such as integration, stability and borders’ defence. Rome had grown too much for its strength to remain unaffected; the Empire lost control and slowly collapsed, surrendering to barbarian invasions, civil wars and plagues. This excessive size doomed one of the strongest empires ever and it is our opinion it can often be a detractor to the performance of investment strategies as well.

As assets invested in a strategy grow, it becomes harder for managers to be as nimble as they need to as they face higher indirect trading costs such as market impact and liquidity issues. Additionally, large assets strongly limit the ability to invest in smaller companies or to properly express views in certain sectors or regions. Therefore, overgrown funds are not able to replicate the same investment process that attracted assets in the first place and they inevitably end up drifting towards more liquid securities or looking more benchmark-like. Clearly every strategy is unique and investment conditions change continuously, so capacity can only be estimated on an ad-hoc basis and never without uncertainty, but rigorous capacity management is necessary to avoid performance erosion and style drift.

When evaluating investment teams, what we generally find to be most effective are small teams with sufficient resources whilst avoiding the dispersion and the lack of direct responsibility that we often observe in oversized teams. Focus is key and when information is spread across too many people, decision makers struggle to have a complete understanding while analysts miss the bigger picture. Concerning firms, we simply do not believe there are any firms that can be the best at everything. Rather, there are many smaller asset managers specialised in specific asset classes or strategies as much as in the larger companies there could be a small number of highly valuable teams. Our ability to invest in as many managers as we want enables us to pick just the “best of breed” within each component of our portfolios.

These are no hard rules, rather guidelines we have often found to be adding value in the investment process. We typically build higher conviction in specialised firms, where portfolio managers are also analysts with alignment to long-term performances rather than assets under management. How to measure and quantify the above characteristics is not an easy task and one must not be too simplistic when trading size off with the many advantages of being instead large (among many, a better structure for passive solutions and large scale products), but it is an important factor that we believe having a significant impact on investment returns despite being often overlooked or misunderstood by others.

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