At Havener, when we meet with an asset manager who is launching a mutual fund and looking for marketing help, one of the questions we ask them is, “What is the capacity limit for this strategy?” This question is usually met with a chuckle, snort, or sideways look as the mutual fund may only have $25 or $50 mm in seed money. Yet, there we sit, pens poised, awaiting an answer. Why is it important to think about the asset level at which you would close your mutual fund when you just opened the doors?
1. Many mutual funds fail at knowing when to say when.
This industry phenomenon is seen time and time again: talented portfolio manager with solid, repeatable investment process generates strong performance, garners attention from investors, assets grow and grow some more, until the fund is too big, performance suffers, investors redeem, assets decline, performance suffers and suffers some more, and the vicious cycle continues until … the party screeches to a grinding halt. It’s the investment management version of Icarus flying too close to the sun; he gets burned and the investors do too.
2. Alpha, Alpha, Alpha
Asset bloat might be kryptonite to alpha generation. The direct source of any causal relationship has been the subject of many academic papers (diseconomies of scale, investor behavior, etc.) I’m not an academic, but my street sense view of the scenario is – asset bloat is a problem. Active management is challenging enough without introducing additional hurdles. If one of your values is to strive to deliver consistent outperformance for your investors, then perhaps a worthwhile exercise is to identify the known obstacles that could derail that mission as well as your mutual fund distribution plan. Identify them and be ready to steer clear (or pump the brakes as the case may be).
3. You will be asked. You need an answer. You need to stick to it.
As Vince Lombardi said about the end zone, “Act like you have been there before.” Don’t laugh when someone asks, “What is your capacity?” The behavioral read is that you find it humorous to think anyone would ever invest that much money with you. Take the question seriously. If you are lucky, it will be a “problem” you will face in the future. Realize too that the number you say in the early days will be the number people expect you to honor. If it feels better, give people an AUM range (a range within reasonable bounds like $2 - $3 billion, not somewhere between Infinity and Beyond), and let them know you will monitor capacity as assets grow to watch for deterioration of alpha (if that is indeed a true statement).
4. The soft close is the power play.
When we say close, we mean a soft close. Why? A soft close can create some urgency in your mutual fund distribution strategy since investors can’t drag their due diligence on too long lest they miss the proverbial boat. It fosters loyalty and affords respect to your early investors who found you “first”. Above all, put yourself in the shoes of the advisor facing a hard close: Most of my clients are in Fund X, but now you are hard closing, so all my new clients have to be in Fund Y (which I have to go find now, thanks a lot) and that can create all kinds of dispersion issues and operational headaches. Why don’t I just move everyone to Fund Y? Nice one, Fund X. Total botch job.
The time to contemplate your capacity limits and AUM number is well before you reach it - as in, when you are starting your mutual fund and are building out your distribution plan. Be thoughtful about your approach to asset gathering. Honor your commitment to your existing investors to be a good steward of their capital. Remind yourself of the whole Icarus thing, and if that doesn’t resonate, there’s always this one: Pigs get fat, hogs get slaughtered.