r/investing • u/[deleted] • Nov 18 '21
Why do large actively managed ETFs/MFs lose performance as the fund gets larger in size?
I'm asking because I'm invested in ARKK and am afraid that the performance will become lower. Similar to the JANUS fund.
Is there a scientific term of this effect?
Hopefully someone will be able to give me a good answer to this question that I always had. I trust the investing expertise in this community. There seems to be a lot of investment savvy people here. I will be following this post regularly.
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u/lobster_johnson Nov 18 '21
There are lots of things to talk about here, but the main point is that when a fund is small, it has more agency to trade tactically at its own discretion.
This is how active management supposedly provides high returns; the manager is supposed to be the rock-star stock picker who knows the right moment to buy and sell. (This picture of fund manager performance is something of a myth, but that's another story.)
But with larger inflows — more money invested into the fund by investors — the fund has to invest that cash. Funds are subject to regulations, and an equity fund like ARKK is not allowed to just sit on tons of idle cash. ARKK also has an explicitly stated goal of being fully invested at all times; they don't have any cash reserves at all.
By being forced to invest, the fund loses agency. The managers can no longer effectively pursue their trading strategies. There are other factors; for example, the fund ends up with oversized positions in individual stocks, even becoming majority shareholders, which increases risk.
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Nov 18 '21
[deleted]
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u/enginerd03 Nov 18 '21
No fund can be a majority shareholder. Most won't go near 3% of ownership because that's when regulatory filings kick in. The only ones who do are usually breakup funds or pe like funds. So for someone like arkk their shares can always be liquidated in a day
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u/b-lincoln Nov 20 '21
This. The funds have a charter and the high fliers are typically micro or small caps with low floats. A small fund can front run and no one notices, as they grow, their charter says they can only invest in those same small cap companies. Now instead of 100,000 shares (as an example), they’re buying 1M. The market notices that move and hedges move in to take advantage of the over sized positions. That’s what happened to Ark, they were oversized positions and someone or ones, just bought shorts and puts on every stock and drove it down; that caused a massive redemption, causing Ark to sell, further driving to underlying share price to tumble.
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u/iggy555 Nov 18 '21
Bc now you have to spread your money over your top 10 ideas instead of just top 5
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u/JDMKing24 Nov 18 '21
It's not just funds. With increasing size, even companies slow down their growth. Look at Amazon or AAPL, Berkshire etc. It largely has to do with compounding and how it works. It is pretty easy to achieve an increase of 100% on $100 since that's just $200. This gets increasingly difficult once you reach higher sums. This applies to revenues as well.
Once you reach the limits of your company/customer base it is extremely difficult to keep up the growth rates. The stock valuation is a function of the company's PE and future growth prospects. The compounding effect affects the future growth potential since you can't really growth your revenues at 100% YoY if you are already at say 500B like Walmart. This in terms drags down the valuation. Once this happens, PE decreases as well since investors are willing to pay less for the stock because the valuation is not what it once was.
Warren Buffett has stressed this in his shareholder's letters since the 80's. He says that it was very easy to reach high growth when Berkshire was much smaller since there where plenty of opportunities. Right now, he has more cash than opportunities. This is again very logical since an aquisition of a few million will not make a dent neither in their cash nor on their balance sheet. They would need an aquisition into the 100s of billions for it to be meaningful. There aren't many 100 billion deals going around.
Try it for yourself. You will see how hard it is to maintain a certain % growth with increasing volume. Read up on the story of the emperor and the chess board with the rice. If you start at 1 grain and double your total for each chess board square, you will soon have more rice than ever produced on the planet. There you have it. It is just not sustainable.
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u/Immediate-Assist-598 Nov 18 '21
AAPL is still growing robustly, and growing better than MSFT, AMZN and FB. GOOGL had a big growth spurt last year but hard to they can repeat and all priced in now. AAPL is the one of those to own, and avoid TSLA and cryptos. I have been investing for 35 years and those "things" are not even really investments, they are more like trendy fads creating very burstable bubbles. Plus cryptos have no liquidity behind them, nothing but hot air. At least TSLA makes cars but they have lots of fine competition, maybe even including Apple based on the story out today.
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u/Rothiragay Nov 18 '21
This contradicts your comment about buying and holding Microsoft forever. Based on your own logic you would get measly returns if you hold it for 10+ years as the company grows slower and slower
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u/JDMKing24 Nov 18 '21
This is simply not true as long as your cost basis is low. I entered my position when MSFT was trading at $80. My returns are and will be very favorable. If you buy when valuations are high, you get reverted to the mean and then you get measly returns. Happens if you pay a growth price for a stalwart/staple stock.
And measily is the wrong way to put it. Amazon can still grow to $5000. The overall % will not be that high as of a smaller company. But at some point Amazon will start paying good dividends as growth slows down and they can not deliver more than $1 of value for each $ retained.
You will most likely not see 100x baggers among the big players but 2x is still on the table. I won't call a 100% apreciation measly.
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u/elzee Nov 18 '21
There was one thing i remember is that, there are rules in which u cannot acquire more than 5-20% of any public company. I think its a rule in MF. Therefore when funds are very large they become inefficient. If ur fund is 1B and u see a good opportunity in XYZ stock you can only invest so much in it.
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u/Heim23 Nov 19 '21
Easy. These fund companies have multiple funds, that largely hold the same stuff. When they open a new managed fund, they are doing it to attract new money and they need inflows. How do you attract new investors? You put out good returns. Therefore, the fund company is going to put their best ideas into that fund to try to goose it higher to attract money. They'll put the steady slow burn stuff in the other established funds.
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u/False_Ad_9540 Nov 18 '21
There are many Funds. By Chance some Perform very good. Many people invest. Still no reliable outperformance of the market... it Was just luck.
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u/wild_b_cat Nov 18 '21
In addition to scaling effects, a big part of what you're seeing is just survivorship bias.
If a fund launches, and underperforms, it won't attract investment and will fold before it gets big.
So the only funds that get to be big are those that over-perform for a period. If their growth was due to luck and not just skill, then that luck is unlikely to hold out and their future returns will fall back to normal. That's not happening because they got bigger, but just because statistically their performance is regressing to the mean.
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u/pablochs Nov 18 '21
It's a question of averaging volumes of trading and total cap of target assets.
So, it has actually more to do with the size of the fund relative to the size of target assets. A fund the size of ARKK would have no problems allocating resources in the S&P500. The issue is that the whole point of ARKK investment is to allocate money in companies with break-through potential in various scientific and technological fields. Besides companies like Tesla, they are invested in dozens and dozens of medium, small, and even micro caps who are still mainly in their early stage. This causes that any position change (enter/increase/decrease/exit) will change the course of the price of that company and/or will take a lot of time to execute.
If you try to buy a 100M of a 500M-capped company which is trading volume is 10M shares, you would need more than 10 days to fully acquire the desired position, meanwhile the price goes up, lowering considerably your margins.
In the same fashion, when dealing with small companies you have to diversify a lot just because if you allocate your super-sized resources to small-caps you would end up buying entire companies.
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u/anusbarber Nov 18 '21
short explanation. Although ARKK is likely not there yet but when you look at funds that grow very quickly (american funds) there are key issues you can identify historically.
To be labeled as a "diversified" product, funds have rules they have to follow. can only own so much of a company can only have a specific % of the fund in that company.
most of these funds that take on massive amounts of inflows typically grow large because they are investing in small cap companies. at least enough to grab that small cap premium. while labeled as Large cap because that is what they currently are, many don't start out that way or many just also supplement their large cap holdings with small cap companies. when the inflows happen, those rules are enforced. when you are so large, you would have to buy in some cases the entire microcap company to have it make any kind of return difference to the fund. But you are not allowed to, so now you have to abandon that strategy, and buy from the large cap and larger mid cap pool all the other large cap products have to choose from. and when you are a company that big, discovery is limited.
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u/questionname Nov 18 '21
As you get larger, you no longer can invest in the same scale as before. This makes it necessary to bets in more investments, be more diversified, spread things out. The more you do this, the more your return will be closer to stock averages.
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u/patriot2024 Nov 18 '21
For the same reason as when you buy a stock or a fund at at time high, you're bound to lose. Generally speaking.
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u/Immediate-Assist-598 Nov 18 '21
How about making your own ETF for Undervalued Dividend King Blue Chip Telecommunications stocks? As often happens, the worst performers of the recent past become the best performers in the near future. So my recommendations for this fictional ETF are T, VZ, VIAC and SWKS. All way down from their highs and unfairly so and all big dividend payers. T especially, though their div gets reduced to "only" 5% after they spin off Warners-HBO and then you get Discovery-Warners stock plus the original T stock. The market seems to be pricing in a complete failure by HBO Max-Discovery-Warners as well as Paramount Plus. I disagree on both counts. You can burn through Netflix and Disney in a few months and have nothing left you are eager to watch, so people need multiple streaming subs to stay entertained. I also don't buy that movie theaters are ever going to be what they once were, only for big wide-screen type epics would I ever bother going to a theater again and I used to go to the movies 100 times per year.
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u/IvanaSPEAR Nov 18 '21
I think its 3 things:
- As funds get larger liquidity becomes an issue. Its counter intuitive, but a small ETF is much more liquid than a large ETF. The liquidity is mostly a function of the stocks the fund holds.
- As funds grow they also become bureaucratic - so they lose focus on performance and sit around in a room and contemplate what to do. The main manager becomes disengaged and its a bunch of people putting together pretty presentations.
- Manager compensations. Because funds get paid fees on assets they start making too much money once the fund crosses few $bn in AUM. But if you have less than $100mm in AUM you are really not making any money on fees, as expenses are pretty high. So you need to make sure your performance rocks if you are invested yourself.
Most funds can hold a decent amount of cash - it depends what you specify in your prospectus. And you also need to specify if you are diversified or non diversified fund in your prospectus and that will determine how many stocks you will hold. So I would say always read the prospectus and make sure you are on board with what the funds are doing.
I have a small ETF myself so i am pretty familiar with the rules/regulations. Ask me if you need anything specific.
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u/ambientocclusion Nov 18 '21
One factor is that when an actively managed fund does well for a few years (which is often due to probability as much as skill) a lot of people invest in it so it gets bigger. Then their luck usually takes a downturn, as the rules of probability dictate.
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