Conviction versus capacity

Boutiques face a difficult balancing act, writes Ian Jones

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Boutique asset managers are typically defined as small asset managers, and often there is a ceiling to the amount of assets under management that a firm can have in order to be called a boutique. However, the accepted definition is more nuanced than that, referring to a small firm that is independently-operated and that has a specialisation or expertise in a particular segment or area of investing. Internationally, boutiques are managers that focus on a specific niche.

In South Africa, we have a number of small asset management firms that would be classified as boutiques if size was used as the only determinant. However, the majority of these firms offer a range of funds or strategies (equity, multi-asset, fixed income) so it is difficult to point to a niche or speciality. In many cases, boutique asset managers in South Africa are just small asset managers that have not yet reached scale.

Larger investable universe

The main advantage that boutique asset managers point to as their key differentiator is that they have a larger investable universe. This increase in the number of investment opportunities from which they can build a portfolio should provide them with the potential to outperform larger managers over time.

To put this in context, let us consider the South African listed equity universe by taking a closer look at the FTSE-JSE All Share Index (ALSI). The ALSI is comprised of 166 shares. Each of these shares has a free float market capitalisation which effectively represents the Rand amount that could be invested in that stock at a point in time. Asset managers will generally set risk constraints to ensure that position sizes in their portfolio do not take on undue risk and to ensure diversification. For example, a manager may adopt the following two constraints:

The maximum holding as a percentage of the free float of any stock is restricted to 15%, given the risks associated with owning too much of any company if the asset manager wants to exit without materially impacting the share price while selling down.
The minimum weight of an individual stock in the portfolio is set at 2.5%, to ensure that any position taken has a material impact on the portfolio and to avoid over-diversification across holdings.
If we apply these constraints to different levels of domestic equities under management, we can see how quickly the number of shares that are in the investable universe decreases as asset levels increase.

From the table above, we can see that a small manager with R10bn in listed SA equity is able to invest in 153 different shares (if we applied constraints limiting the manager to 15% of the free float, and a minimum weight of 2.5%) compared to a very large manager with R200bn in listed SA equity with a universe of only 40 shares. These additional investable opportunities are a massive advantage and it is not unreasonable to expect boutique managers to outperform their larger competitors over time. In practice, however, only a few boutique managers have been able to use this advantage and outperform the larger independent managers.

Revenue is still important

One of the main reasons that many smaller managers struggle to compete on performance (despite the supposed advantages of their smaller size) is linked to the lower revenue that is a consequence of having lower assets under management. Investment professionals are well remunerated and in order to attract and retain good people, the asset manager needs to be able to incentivise the investment team appropriately. The ability to build a strong investment team that is large enough to cover the investment universe can be a challenge for a smaller manager as revenue may limit the number of individuals that can be hired. In addition, attracting the top investment talent can also be more difficult for a boutique manager given the strength of some of the larger brands.

Even if a manager outsources the majority of their back-office functions and keeps their overheads and operational costs low, the Rand amount of those costs is material and consumes a not insignificant portion of the revenue. Senior members of the investment team are also often required to be involved in business or operational issues, which takes the focus away from investing.

It is a generalisation, but many boutiques struggle to do the depth of fundamental research on the extended universe at the required quality to allow them to take advantage of those additional opportunities. There is little point in having access to a broader universe but not having the team or capability to cover that universe properly. The few boutique managers that are able to get this balance right present great opportunities for investors.

Active share1 or tracking error2

As a way of illustrating this ability to outperform, boutiques will often point to their ability to have higher active share or higher tracking error. We would agree that having a higher active share or tracking error does provide the opportunity for a manager to outperform, but the reality is that the manager still needs to get the calls right. Taking high conviction positions in a particular equity will clearly only add materially to performance if the call is right. If the call is wrong, the conviction will result in a larger negative contribution to performance.

In summary, we do believe that boutique asset managers have the ability to implement their views with higher conviction than a large manager, and that they have an investable universe with considerably more opportunities. However, care needs to be taken by investors as the ability for a boutique to carry out the necessary fundamental research to ensure that they get more of their high conviction calls right than wrong can be limited by their team breadth and focus. It is a balancing act that most boutiques constantly grapple with. 

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