Big Funds Squeeze Out Small Shops: Well-Articulated Investment Stories Make the Difference
May 8, 2006
When Neil Hennessy launched the Hennessy Funds 10 years ago, he knew that to stack up against the 8,000 competitors already in the game, he'd need to come up with a unique investment story.
"The challenges to entry in 1996 were the same as they are today. How are you going to distinguish yourself?" said Hennessy, who serves as president and portfolio manager of the six-fund family, as well as chairman and CEO of Hennessy Advisors of Novato, Calif.
For Hennessy, that differentiation was quantitative analysis, which in the mid-1990s was still a relatively obscure investment strategy. But unlike most quantitative analysis, which is empirical and highly complex, Hennessy's process uses simple formulas that even the layman can grasp. Those formulas are contained in the firm's fund prospectuses and posted at its website.
"What you see is what you get, and nothing can be changed without a shareholder vote," Hennessey said.
That straightforward approach has paid off, as the firm now boasts four Morningstar-ranked products and just over $2 billion in assets under management.
Industry-wide, however, Hennessy's story is becoming rarer every day, experts say. Not only are fewer entrepreneurs joining the game, more players are exiting. According to the New York-based consulting firm Strategic Insight, 15% of the fund managers that existed at the end of 2002 - some large, but mostly small - are no longer in business. In that same period, more than 1,300 portfolios were similarly liquidated or merged.
The Big Three
And hulking giants like Fidelity Investments, Vanguard Group and Capital Group's American Funds have been picking up the pieces. Collectively, according to Lipper of New York, the "big three" now manage close to $3 trillion of the $8.6 trillion in assets under management across 520 open-end mutual fund firms. That's nearly twice what the three firms controlled in 2000.
It's a shame, too, experts say, because small fund shops typically deliver superior performance. They're also a breeding ground for innovation and oftentimes are home to the industry's next star portfolio manager.
It's also a surprising development, because the industry itself has relatively few barriers to entry. Infrastructure costs, for example, have always been low. An abundance of third-party service providers allows entrepreneurs the time to focus exclusively on investment management and asset gathering. And a sharp increase in distribution channels in recent years, as well as the proliferation of the Internet, has given fund firms access to customers like never before.
"In today's marketplace, smaller fund shops have a real tough go of it," said Tim Armour, a managing director at Morningstar, during a recent conference discussion on the topic.
"Think of what it was like when we tried to get into college and compare it to today," he continued. "You can't make the grade any longer just because you're good at tennis and you got straight As in biology. You have to be good at everything."
Avi Nachmany, director of research at Strategic Insight, points to an overly price-sensitive consumer and the ability of big funds to take a page from the playbook of smaller funds.
"It has become difficult to be successful in this business when the only thing you have to deliver is beta and above-average costs," Nachmany said. At the same time, he added, "bigger firms, like American Funds and Vanguard, have experienced rapid growth through well-articulated investment processes," an expertise normally reserved for the smaller guys.
Hennessy admits that economies of scale, as well as deep marketing pockets, favor the big guys. But he also thinks too much is made of expense ratios, and smaller funds would be well served by underscoring that fact when they tell their investment stories.
"Charge what you want to charge," Hennessy said. "People are going to go with you, or they're not going to go with you, depending on net return."
For example, the Growth Fund of American at American Funds controls about $140 billion and has an expense ratio of 0.66%. A four-star Morningstar fund, it's beaten the S&P 500 over the last five years by 5.15%. The Hennessy Cornerstone Growth Fund, which also touts four stars from the Chicago fund tracker, has less than $1.5 billion under management and a much higher expense ratio of 1.23%. But it's up on the S&P 500 over the last five years by 15.19%, according to performance figures net of fees from Morningstar.
Performance, however, can be ephemeral, and with fewer products to offer as an alternative, smaller funds would again seem to be at a disadvantage. But Hennessy said small funds can overcome this disadvantage by communicating regularly with their shareholders. He recalled the bull market of 2000, "when people were throwing money into mutual funds" but had little investing experience. When the bear market arrived in 2001 and 2002, the losses scared many of them out of the market.