In searching for a restaurant, why would you limit the search to restaurants starting with the letter “R”? Doing so could leave out huge swaths of great restaurants. Why limit the search for a movie to ones filmed in Los Angeles? You wouldn’t. A little gem might lurk in that part of the opportunity set you randomly choose to ignore.
Arbitrarily restricting the opportunity set limits options and fewer options could mean missing your best option.
Yet many asset managers do just that. They reduce their opportunity set in order to grow assets under management.
The distribution of the global opportunity set for publicly-traded equities is like a pyramid: a few big companies at the top and many small companies at the bottom. Of all the publicly-traded equities globally, more than 60% have market capitalizations less than $1 billion and more than 90% are less than $10 billion.
Asset managers with billions of dollars of assets under management cannot invest in the smaller companies at the base of the pyramid and still have that investment be a meaningful contributor to performance. The manager is just too big relative to the size of those companies. Growing assets under management forces managers to move up the pyramid, which reduces that manager’s opportunity set.
Make no mistake, asset managers have a powerful financial incentive to grow assets under management. More assets under management means more fees, which is the lifeblood of asset managers. But growing assets under management also reduces the opportunity set, which in the end limits their returns.
Many managers further restrict the opportunity set based on geography, industry, and even the characteristics of the investment itself. Asset managers impose most of these restrictions on themselves in order to grow assets, again at the cost of returns.
Many investment mandates today face restrictions based on certain social and environmental characteristics. We are not against such mandates, but the restrictions they impose will limit returns over time. They have to.
An asset manager with a broader mandate has all the options available to the manager with the more limited mandate plus more options that are off limits to the manager with the narrower mandate. If both managers are good at their jobs and stay within their investment mandate, the former should outperform over time.
Asset managers that restrict the scope of their investment search geographically or by growth or by value limit returns in a similar way. The narrower mandates face restrictions that the broader mandate doesn’t.
To put the restrictions in context, there are about 25,000 actively-traded public equities globally today. At KP7, we consider about 14,000 of those in our investable opportunity set – market capitalizations above $500 million, all geographies, all industries.
An asset manager with a “Large Cap U.S. Value” mandate, by comparison, has an opportunity set of about 140 today (with “Large Cap” defined as $10 billion market cap and up, U.S. defined as domiciled in the U.S., and value defined as trading at less than 15x earnings).
A Large Cap U.S. Value manager faces enormous restrictions. What we see in practice is most managers with highly restrictive mandates, including Large Cap U.S. Value as well as many so-called ESG funds, do not invest according to their mandate. Emerging market investments start creeping into Large Cap U.S. Value portfolios.
At KP7, we have a broad mandate. We narrow the scope of our investment activities to those portions of the investment landscape that we believe contain high concentrations of great investments. Narrowing the scope in that way enhances the productivity of our research efforts and increases the chances of finding a great investment option.
In The Sting of the Consensus, we described how getting sucked into actually believing what the consensus has to say is one big pitfall of active management. The consensus is frequently wrong and when it is you don’t want to join the consensus in the rush to the exit.
In Fresh Kill, we described how failing to recognize the competitive zero-sum-game element of the asset management business is a second pitfall. Value is transferred from one party to another every time a mispriced security changes hands.
Here we describe the foolish practice of reducing the opportunity set in order to grow assets under management. A powerful incentive exists to grow assets, yet actively growing assets at some point reduces the opportunity set and limits returns.
All three pitfalls turn unsuspecting asset managers with good intentions into deadbeat managers with lousy long-term records.
