Why Blockbuster Funds go Bust
One of the biggest killers of good asset management companies is too much money flowing into too few products too quickly. Blockbusters can both make and break asset managers.
Not all fund flows should be equally valued. A key component in analyzing the volumes of AuM gathered is the quality of flows. Sustainable blockbuster AuM levels are built on high quality flows. Measures of quality are strongly correlated with the timing of flows. Higher quality is found in early flows; later flows show a marked decrease. Quality has a lot to do with the ‘intellectual commitment’ level of investors beyond reacting to good past performance. As blockbusters grow in size, particularly in the late stage of the growth cycle, the average quality of assets tend to decline. This creates fragile and unstable situations ultimately leading to busts. Know thine investors.
A greater proportion of asset flows have been concentrated into an increasingly limited number of funds – particularly since the turmoil of 2008. The big are getting bigger while others are sitting on the sidelines. Some industry pundits have concluded that either there are no longer opportunities for boutiques or that the only way to succeed as a manager is via a blockbuster. Is a blockbuster at all costs the holy grail?
The demise of asset managers and the blockbuster investment products that propelled their (short-lived) success are well-documented. Ex-post, the reasons appear so clear: market shifts, hubris, greed, lack of planning, mistaking talent for luck, performance falling apart, manager loosing his/her way, not foreseeing evolving trends and insular firm-level thinking all are influencing factors.
But what is equally important (and at fault) are the decision making processes of investors who themselves contribute the blocks of money to create a blockbuster.
With skepticism riding shotgun, let’s think through how blockbuster funds reach stratospheric status and then quickly come back to Earth – both at the hands of the investors who were responsible for the massive flows that built them.
- As time progresses, there tends to be a cruel relationship between the quality and the volume of flows into a given investment product. Volume of flows goes up while the quality of flows goes down.
- The difference in quality and quantity of AuM is important and too often not understood and/or paid attention to – by either investors in the products or the asset managers who manage them.
- We use the term ‘quality’ to denote those assets which are invested based on a substantially robust due diligence process and therefore understanding and intellectual commitment to the investment strategies’ characteristics, philosophy and process. Simply stated, high quality AuM is the opposite of hot money blindly chasing good past performance.
- In the world of active, limited capacity management, as a fund grows in size, (from $1 -$25 billion in AuM for instance), the ‘late stage’ investments are generally less knowledgeable, less seasoned and therefore less ‘patient’ than the earliest investments. They are, in our model, of lower quality and deserve a lower ‘multiple’ from a valuation and a future revenue generation point of view.
- Low quality assets might in fact be viewed as a liability in environments lacking liquidity or in which large flows create outsized cash positions that can be a drag on performance.
- Generally, forward potential outperformance becomes increasingly reduced (due to compression of alpha-potential) as time progresses and asset size grows all the while, money continues to flow in blindly seeking those opportunities.
- Coincidentally, the lowest quality assets have tremendous implications on the problems faced by a fund in net redemptions due to what we might term as an AuM fragility function. These assets are the proverbial straw that breaks the back of the camel. This is particularly true in narrowing liquidity environments.
- Under the following assumptions: performance remains at a consistently high ranking (say 1st-2nd quartile) over the crucial evaluation periods (12 & 36 months), there is often an intermediate term influx period when the quantity of assets increases while the quality of the assets declines – both at an accelerating rate. At this point, the fund as a ‘default option’ may enjoy (and then suffer from) the autoflow function.
- In an odd twist, the intermediaries who act as leverage points for distribution (global consultants, global financial institutions, etc.) have completed their work during their initial investment stage. Once ‘approved’ or on the ‘list’, the manager slips to ‘monitoring phase’ with a primary focus moving from process to results. Quite simply, the amount of qualitative and operational due diligence performed tends to be reduced at a rate relative to how ‘established’ a fund is.
- Strong performance (even moderate performance following a sufficiently long period once an initial recommendation has been made) perpetuates flows – this we have labeled as part of the ‘auto-flow’ function. Turning off or slowing these flows present considerable challenges but necessary to preserve the integrity of the investment product and investors.
- In the event of market turmoil, or poor performance of the investment product, outflows from investment products generally follow the LIFO (last in first out) accounting rule. That is, the lowest ‘quality’ assets, are the first to leave. It is equally important to recognise that late stage investors do not enjoy a cumulative strong performance record. They do not have the benefit of ‘playing with the house’s money’. This is exacerbated with illiquidity and market shifts (asset allocation away from fixed income to equity for instance…)
- There are clear implications of a blockbuster on non-direct investment functions within an asset manager. Further, as the fund grows in size, too commonly the necessary support functions needed to maintain the health of the larger structure remain sub-scale – operations, administration, risk management, client servicing. Blockbusters also have important implications for sales functions within asset managers – particularly those paid on a ‘gross sales’ basis.
- These factors are inter-related and have causal relationships.