Size is the Enemy of Performance

“Prices fluctuate more than values – so therein lies opportunity.” – Joel Greenblatt

I saw Joel Greenblatt speak at the Morningstar Conference earlier this summer. He has the uncanny ability to explain the markets and his investment process in a manner than everyone can understand which is not an easy thing to do for many in the world of finance.

For those that don’t know Greenblatt, he’s the author of the well-known investment books You Can Be a Stock Market Genius and The Little Book That Beats the Market.

Barron’s had a nice profile on Greenblatt and this nugget on his past performance caught my eye:

Using an über-concentrated deep-value approach, the hedge fund he founded in 1985 produced 34% average annual gains, after fees and expenses, for the first decade. At the end of 1994, Greenblatt and his longtime partner, Rob Goldstein, concluded that their growing asset base would impede future returns because their approach was so narrow. They returned shareholders’ money and stopped taking outside investments—though they kept their staff and continued to manage their own capital.

There’s a lot of information to digest from this paragraph. First of all, Greenblatt’s returns were phenomenal. Granted this was a ten year stretch that saw the S&P 500 return 14.3% per year, but his fund more than doubled that performance figure. His fund’s annual returns would have turned $100,000 into $1.8 million in a decade.

Also, he returned outside investor capital before another four years of 20%+ annual performance in the market. With a decade-long track record showing 34% annual gains Greenblatt could have raised money from anyone he wanted and lived off the management fees. He basically decided close the fund at the absolute apex of the market when they could have sold this thing to every wealthy investor in the country.

It’s extremely rare in the investment business to look out for shareholder interests in this way and not try to cash in on past successes. I don’t blame funds that build an established track record for using it to their advantage to fund-raise, but it’s rare for a portfolio manager to admit their opportunity set is limited because of their size.

Warren Buffett talked about the problem that investment success can bring about in his 1995 shareholder letter:

The giant disadvantage we face is size: In the early years, we needed only good ideas, but now we need good big ideas. Unfortunately, the difficulty of finding these grows in direct proportion to our financial success, a problem that increasingly erodes our strengths.

The problem is that it’s unlikely that a portfolio manager or fund marketing executive will admit that size is the enemy of investment performance. It’s really up to the investor to set realistic expectations for the scale of any strategy they invest in by ensuring there are enough opportunities and liquidity available in the investable universe.

This doesn’t mean you should give up on a fund or strategy simply because it attracts investor capital. But it does mean that investors need to be aware of the possibilities for expected future returns based on size of the fund when the performance was earned in relation to the current size of the fund.

The life cycle of many successful funds goes like this: (1) Establish a solid track record with a small amount of invested capital, (2) Attract new capital based on the performance history and (3) And after too much new money has entered the fund, underperform because it is much harder to secure big gains with a larger fund size.

In a way past outperformance can be a fund manager’s biggest hurdle for future outperformance.

Source:
Writing a bigger book (Barron’s)

Further Reading:
Adam Sandler and Complacency Risk