The installation of a new portfolio manager for the Fidelity Magellan fund received a great deal of press recently, but very little in the way of actual insight. However, Daniel Gross at Slate.com provides some insight.
The challenge of managing a fund the size of Magellan has brought down the fund’s past few managers. One fund that has so far eluded the challenge of managing megabucks is American Funds’ Growth Fund of America which now has $117 billion in assets.
The secret to its success? Parent company American Funds managed to stay out of trouble and put up a lot of good numbers in a period when rival companies like Janus were covering themselves in ignominy. The fact that Growth Fund of America has crushed the S&P 500 during the last two years has also helped. And while Growth Fund of America isn’t a hedge fund by any stretch of the imagination, it mimics them in some ways. Unlike Magellan, which is managed by a single emperor, Growth Funds’ assets are divided into several portfolios managed by individual managers, each with his or her own team of analysts. They take a more catholic approach to investing than Magellan did, with more foreign stocks and corporate bonds, for example.
Gross notes that most hedge funds limit their growth at some point, for fear of putting their performance fees into jeopardy. He is skeptical that the streak can continue.
The managers of Growth Fund of America have beaten the market while amassing the largest pile of assets in the mutual-fund universe. But if history is any guide, they won’t be able to continue to do both for long.
This problem of falling returns with asset size has not put off one firm. According to breakingviews in the Wall Street Journal, Renaissance Technologies is in the process of raising a long-only equity hedge fund. The Renaissance Institutional Equities Fund is designed to manage up to $100 billion. The prospect of such a fund is not promising.
Academic research suggests an inverse relationship between fund size and investment performance. Warren Buffett has frequently reiterated this point. Large funds tend to overlook small stocks, where the best investment prospects often lie. Furthermore, even if they pick a winning small-cap stock, this has a limited effect on a huge fund’s overall performance. Large funds also face liquidity constraints. Their large-scale trading activities can make shares they are acquiring jump up in price.
How can Renaissance overcome these problems? The firm won’t say. What we do know is that this is a quantitative fund using mathematical models to reach investment decisions. Others have profitably applied quant techniques to equity investing. And Renaissance has an extraordinary track record. Over the past 15 years, its Medallion Fund has produced annual returns above 30%, net of fees, far outpacing major market measures.
It is not clear whether the $100 billion estimate is marketing hyperbole or a genuine belief in the underlying investment process. In either case, the track record for managers in that stratosphere is not altogether promising.