The decision-making process around most product purchases usually involves four factors; brand or reputation, price, client service and performance.
As consumers apply these factors, they often show weak persistency (loyalty), even for large ticket purchases such as vehicles – most own different brands during their lives and are remarkably disloyal. Disloyalty is usually even greater when service providers are selected, asset managers being prime examples. The decision making process can be more complex, less rational, quite ethereal with softer, hidden factors. Yet in the South African market, until recently, entrenched large managers have been impervious to an intensifying competitive landscape. The following reasons contextualise their resilience:
- Exceptional results – our market is occupied by skilled investment professionals, over the years certain of these individuals have been attracted and applied their trade within large investment houses, effectively putting these companies on the map.
- Risk aversion – big is perceived as safe. There is supposed risk reduction in numbers even though herding is fatal in markets.
- Anchoring – an irrational bias for a psychological benchmark – five years ago, entrenched ‘big brand’ managers were clear outperformers, and although this is no longer the case, many investors continue to anchor on past performance.
- Asymmetry of information – assets within the industry are consolidating around asset aggregators due to legislative reasons. Where aggregators are unskilled investors and fear the reputational damage as a result of underlying manager selection choices, they default to risk aversion and anchoring, by buying incumbent managers, aggravating an industry problem.
- Brand – brand traction is a tectonic force – big managers have the firepower to build big brands, which in turn reinforces their place of dominance.
But fortunately for the industry, for consumers and for impactful, deserving specialist (smaller) managers such as Northstar, the concept that ‘big is better’ is losing its appeal. We provide insights below as to why.
The opposite of big being safe, liquidity risk is a significant factor acting against large managers and playing into the hands of smaller managers. Liquidity risk is particularly evident in non-trending, volatile markets, where corporate failures are rising.
Considering good managers only get approximately six out every ten of their stock picks correct over time, it can be damaging to returns to be paralysed by size and be forced to retain perpetually underperforming companies within a portfolio. It should thus be of no surprise to investors that large managers seem to consistently be caught with businesses in deep trouble – Steinhoff and Aspen come to mind.
To understand this risk, we analysed one of the portfolios of a sizable South African manager and calculated how long it would take to liquidate (sell out of) the top ten positions in the fund. We assumed this would account for 5% of the daily volume traded in each of these ten shares on the JSE. It takes one month, but our analysis fails to capture two issues; the first is that these ten shares are held across most of the asset base of the manager, an asset base 20 times the size of the sample fund, this has significant tail risk should selling be required. Secondly, the top ten shares are large capitalization stocks, the portfolio also holds many mid-sized companies, exiting these would take at best months, if not years.
The same analysis applied to a smaller manager, yields a result that the portfolio can be traded out of in half a day.
Liquidity risk is a significant issue for any manager, it should be equally important when choosing a manager. Smaller managers simply avoid this risk on behalf of their clients!
Big brand managers are no longer the best performers
The idea that large managers are more skilled and better wealth creators is deeply flawed. Instead, the relationship between size and alpha generation (out performance) is an unhappy one. The larger the asset size of a manager, the harder it becomes to capitalise on market mispricing, particularly in lessor-owned stocks.
Figure 1 shows the outperformance of a large manager and specialist (smaller) manager against their peers. Over time, the smaller manager continues to generate peer beating returns, whilst the large manager’s outperformance steadily diminishes and the fund begins to underperform peers. This is not an isolated example in South Africa, a core group of smaller managers, which includes Northstar, are making their mark on the local investment landscape, at the expense of large managers.
Figure 1. Excess five year rolling returns over sector. Source: Morningstar and Bloomberg February 2020.
Price versus value
Price discounting is a theme within our industry, it is being driven by the largest asset managers. To be fair, their moat (competitive advantage) lies in their sizable asset bases. Large asset bases allow them to cut prices and still generate exorbitant profits. But why are they responding in this manner?
Firstly, alternate products, particularly passive investments are stealing their lunch which is an industry problem, and as larger managers can no longer distinguish themselves through performance, price becomes a default weapon. Secondly, within the active industry, competition is intensifying, price discounting is less of an option for smaller rivals and consequently, large managers can flush-out competitors by adopting this approach.
This tactic is being used to good effect on clients who obsess on cost alone, without accounting for net returns. The growing pool of smaller manager outperformers might cost clients marginally more, but their returns after costs are vastly higher. The outperformance trend by smaller managers will continue in the years ahead and savvy clients are recognizing this.
Service – the ultimate differentiator
Our final point revolves around service, where ‘Price is what you pay. Value is what you get’. Investors who are happy to ‘be a number’, where their individual voices are irrelevant, are likely to remain inside large investment businesses. Our experience at Northstar however, is that our clients are discerning, acknowledging personal relationships, and there is a deep distrust for ivory-tower-occupying managers who see the world from stratospheric heights. This is precisely why our business rests on investment competency and deep client connectivity!
The best smaller managers are increasingly coming into their own, but this journey is not without challenges in the form of risk aversion, anchoring, information asymmetry and large manager brand traction. Ultimately though, as outperformance from smaller managers continues and we combine this with our natural instincts for focused, sincere client relationships, the pendulum will permanently swing away from incumbent house-hold name asset managers towards Northstar and other great specialist firms.