WARREN INGRAM: Size really matters in unit trusts

There is a lot of debate about how to select the best unit trust and why new fund managers struggle to attract investors. One of the many factors that investors should consider when selecting a unit trust is how much money is invested in the fund. 

There are many opposing theories about the influence of fund size on performance. Some argue that a smaller fund is better because it can be more agile and flexible, whereas a larger fund might be too ungainly and difficult to manage. This is particularly relevant in SA, where the number of shares on the JSE is declining constantly and so investment choice is increasingly limited.

Bigger is better

Derek Horstmeyer, an associate professor of finance at the George Mason School of Business, penned an article on the impact of fund size on US unit trust performance in the Wall Street Journal on December 8 2019. His findings were remarkable. In the US over five years, large unit trusts outperform small unit trusts in all unit trust categories. As an example, when looking at unit trusts that invest in US shares, there was a 1.5% per year outperformance by large unit trusts over small unit trusts. 

To give you an idea of the effect of this difference, we assume you invested $10,000 in the biggest 25% of unit trusts and invested $10,000 in the smallest 25% of unit trusts in the US. We then assume that the smaller funds grow 10% per year for 10 years, which means you will have $25,937. We already know the larger funds grow by 1.5% per year more than the smaller funds, which means you would have $29,699 in the larger funds. This is $3,762 more simply because you selected larger funds. 

Horstmeyer also looked at funds that invested in non-US shares and found that larger funds beat smaller funds by 0.8% per year over five-year periods. 

The SA difference 

I thought the research from the US was so compelling that I looked at a few return comparisons in SA to see what is happening here. The category of unit trusts that invests in shares is called general equity. I looked at the growth of the largest general equity unit trust, which has been in existence for 10 years — as has the smallest fund.

The biggest fund beat the smallest by 8.01% per year. To give this difference context, 10 years ago if you had invested R10,000 in the biggest fund, you would now have R26,847. If you had invested R10,000 in the smallest fund, you would now have R12,639 — a difference of R14,208.

Out of interest, I also looked at the best-performing fund over 10 years. It wasn’t the biggest fund in the category but it was sizeable. However, the three worst-performing funds over three years were all small funds and the worst performer was the smallest. My comparison is certainly not an academic study, but it does show the same type of trend as observed in the US.

Why the better performance?

In his research, Horstmeyer found a few reasons for the difference in performance. First, smaller funds tend to trade more than larger funds. Smaller funds are also much more volatile — in other words, their values rise and fall much more than larger funds. There is also a bigger range of returns between best and worst smaller funds than there is between bigger funds. This means that if you choose a smaller fund, there is a chance that it could do well but there is a big possibility that it could also do really badly. 

Larger funds have also proved to be much more efficient in the management of costs within the fund as they can spread the running costs across a lot more money. Larger funds also trade less than smaller funds and are generally more efficient in managing their trading costs. This is partly due to their skill but also due to their ability to negotiate better fees from suppliers.

What does this mean?

It is too simplistic to avoid all smaller funds purely because of their size. For example, if a new fund launches and is low cost with a strong focus on long-term investing — not trading — you could still consider it. Similarly, a new low-cost index tracker could be a very compelling investment, because of the diversification benefit, even if the fund is small. We know that low costs are important in determining long-term performance, so the small fund might be a big fund one day.

This also provides some context to the problems new entrants into the SA fund management market face. Financial planners and retirement fund trustees will generally favour more established businesses. A large part of the reason relates to risk and return. If larger funds do better than smaller funds, and smaller funds are proven to be riskier than larger funds, why would a retirement fund trustee take the risk of investing in a new, small fund manager?

• Warren Ingram CFP® is a wealth manager at Galileo Capital. You can follow him @warreningram.