My 5 Rules For Selecting An ASX Small Cap Managed Fund

Like selecting the right ASX small-cap stock, selecting the right ASX small-cap managed fund can be enormously rewarding. While there are no guarantees that any given fund manager will outperform the index, and past performance is not a reliable indicator of future performance, there are very many funds who have achieved noteworthy outperformance over a very long period.

Now, it should go without saying, I would only select a fund manager who I think is capable of beating the market going forward, with their fund as it currently stands. Therefore, I have not included the obvious rule that “I think this person can beat an ASX 200 Index fund” in my 5 rules below.

Of course, I do consider past performance, but the reality is that past performance (for example the last 3 years) is not a good indicator of future performance. I am generally focussed on performance over 5 years or more.

When I select a managed fund, I am looking for fund managers who have designed their businesses to minimise conflicts between the fund manager and his or her clients. These conflicts come up often. And as Charlie Munger said, “Incentives really matter.”

For example, a small-cap fund manager makes more money by increasing funds under management, but that also makes it harder to achieve strong returns in the small-cap segment, because the bigger the fund, the more likely a small stock will prove too illiquid.

One obvious trap for new players is to extrapolate performance achieved with small funds under management, and then presume that the fund manager can repeat that performance with much larger funds under management. There are some very stark examples of where performance prior to, and after, a large increase in funds under management, diverges massively.

Second, the performance fee structure incentivises punting on volatile stocks. Putting aside management fees for a moment, if the fund’s benchmark is 6%, and the fund earns 6% per year for 5 years, then no performance fee is payable. The return after 5 years would be approximately 33.8%.

However, if a fund achieves 10% per annum for the first 4 years, then -50% in year 5, then the total return after 5 years would be about -26%, but the fund manager would have exceeded the benchmark every year for 4 years. If they had a 20% performance fee above the benchmark then they would have taken 0.8% of the value of the fund each year. On a $100m fund that might mean performance fees of around $4m, despite a disastrous result for investors after year 5.

Finally, a fund manager’s incentive is to disincentivise investors from withdrawing money from the fund, either by making it a closed fund or even by suspending redemptions. It is essential that I choose a fund manager that will carefully manage the fund in order to make it possible for investors to withdraw whenever they need to.

Therefore, my five rules for selecting a fund manager are intended to help me select high integrity managers, with a track record of facilitating liquidity for clients.

1. Personal integrity of the fund manager.

This criteria is the most important and the broadest. When you invest alongside a manager in his or her fund, the biggest single factor influencing your likely returns is their integrity. As I’ve covered above, you essentially need the fund manager to feel a personal obligation to prioritise clients’ returns.

In my view, the only way to judge the integrity of someone is to know them for a period of time. That’s because you need to see if their actions match up with their words over the course of time.

Ideally, you would have had the opportunity to correspond with them, listened to them talk, read some of their writing and witnessed their response to mistakes.

I would avoid fund managers who don’t address mistakes where they lost money, or only send out emails after the good performance months, or change the way they present returns in order to make returns look better. I’d avoid managers who don’t tolerate having ideas challenged or publicly promote stocks they are selling.

2. No managers involved in funds that don’t allow regular redemption opportunities at close to net asset value.

As mentioned above, one of the tensions between a manager and an investor is how the investor exits the investment. The service offered by a fund manager who will allow you to redeem your investment at close to net asset value (typically at a cost of around 0.25%) is a much better service than one who demands you find a willing buyer at whatever price, or even refuses redemptions.

Some managers have a great skill in attracting investors who are willing to pay for the lesser privilege of investing in a listed investment company or a listed investment trust. With these vehicles, should you need to exit your investment in a hurry, you may be faced with having to accept a steep discount to net asset value. That’s a huge advantage for the fund manager, and huge disadvantage for any of the people who invest at 100% of NAV.

Now, one approach is to buy into such vehicles at a discount to NAV. This is not moronic, because while you will likely have to sell at a discount to NAV, at least you are also buying at a discount to NAV.

However, I personally eschew any manager who has in the past encouraged investors to invest in a LIC at 100% of NAV, because I am looking for a fund manager who has a more caring attitude towards his or her investors. Obviously, there is real damage done to people who invest at 100% of NAV and then have to sell at a discount, years later. Discounts of 10% are common so this can wipe out a year or more worth of returns for investors. The benefit, of course, goes primarily to the manager.

I would not want to invest with a manager who had previously ever suspended redemptions.

I would also observe how a manager behaves if and when a stock they own is suspended from trade. In some circumstances, the value of that stock must be marked down.

3. The fund manager must disclose funds under management to prospective investors.

Many small cap fund managers do not publicly disclose their funds under management. However, most fund managers will give you a vague indication of what their funds under management is. This is important, because the performance they have achieved with $15m of Funds Under Management is unlikely to be replicated with $50m of funds under management, let alone $150m FUM.

In my view, the best practice is for the fund manager to consistently update the amount of fund with their monthly updates to investors. I intend to keep the majority of funds I control with fund managers who fulfil this somewhat rare level of disclosure.

That said, I also invest with fund managers who don’t publicly disclose the amount of FUM, but are happy to keep investors updated.

4. The funds under management must not exceed a pre-set amount, or grow too quickly due to inflows.

This limitation is the one that catches out the most potential funds I would otherwise invest in. The nature of funds management is that good performance attracts funds under management. If the manager is motivated by making money for themselves, then the incentive is to grow FUM as quickly as possible.

For some managers, who focus on the smallest companies, I would be cautious of investing if FUM $60m or even less. For others, focussing on slightly larger small caps, I would probably still invest up to around a maximum of $200m.

However, if a fund that had been ~$20m doubled to ~$40m in one fell swoop, I would probably consider exiting the fund, since that sudden growth could massively change the odds of success. If the fund grew slowly from $20m to $40m (over a few years), partly due to performance ,and performance remained roughly consistent, then I would be far less likely to consider exiting the fund.

As a general rule, the smaller the fund the better. For this reason, I generally try to only invest in funds with less than $100m FUM. This gives plenty of time and space to increase before I would have to consider exiting due to FUM growth. However, you do need to keep in mind that funds below around $20m in FUM will have to charge higher fees in order to be viable for the fund manager.

5. Fund managers must be aligned, which means they invest substantially all of their liquid assets with the fund, and own the fund manager themselves, or at least control it.

This criteria is absolutely non-negotiable. First of all, if a fund manager has more substantial liquid investments outside their fund, then they are hedging their bets… against themselves. It is of course permissible for fund managers to look after base needs, typically a house and maybe a holiday house for their family. However, a fund manager must have a very substantial investment in their own fund, in order to ensure alignment.

It is very surprising to me how many investors invest in funds run by very large companies, for example. In these cases, the original investor who launched the funds has usually long-gone. Instead the funds are run by someone who is building their career. That means their incentive is to please the fund management organisation. 

But more importantly, it means they don’t even get to make decisions around how much FUM the fund accepts and they cannot be guaranteed they will keep their job if they perform badly for a time. This means that they may feel they have to be more short term focussed. 

My aim is to only invest in a fund manager who can never be fired, and thus can always act according to their integrity.

Thanks for reading my 5 Rules for Selecting an ASX Small-cap Fund. This article is a companion piece to my next article, covering the Small ASX Managed Funds I Like Best.

Important note: Before making any investments read the Product Disclosure Statement (PDS) carefully and consult a financial adviser. This article is not intended to form the basis of an investment decision and is not a recommendation. Any statements that are advice under the law, are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Equity Story Pty Ltd (ABN 94 127 714 998) (AFSL 343937).

The information contained in this report is not intended as and shall not be understood or construed as personal financial product advice. Nothing in this report should be understood as a solicitation or recommendation to buy or sell any financial products. Equity Story Pty Ltd and BlueTree Equity Pty Ltd t/a A Rich Life do not warrant or represent that the information, opinions or conclusions contained in this report are accurate, reliable, complete or current. Future results may materially vary from such opinions, forecasts, projections or forward looking statements. You should be aware that any references to past performance does not indicate or guarantee future performance.