Many would be surprised to see how frequently liquidity becomes an issue for a global fund manager. This depends on the strategy it follows. A screen of companies with certain characteristics invariably narrows the universe of stocks to a manageable level where the investment team can spend time on the industry and the stock-specific issues. The narrower and more specific the criteria, the greater chance that the potential investments are actually quite limited.

It is not uncommon to see no more than 150-200 under serious consideration for a fund compared to the MSCI All Country universe of around 2700. Obviously, the majority are eliminated based on industry or company-specific challenges, valuation or other metrics, yet the capacity to trade the stock in and out is usually out of the spotlight.

A non sequitur question posed to a fund manager is its so-called capacity ie, how big can it get? Smaller funds are considered nimble. Once they get larger, they may not be able to move around as much and, of course, are presumably accruing enough fees not to worry about the risk if they do take a non-consensus view. But the definition of its universe is not scientific metric as market values move and stock liquidity changes.

The reality is that no manager can be clear about its maturating process based on the amount of money it is managing. Large managers of global equities, by default, weigh into big companies that trade frequently. This may not serve the investor best. Other less liquid stocks may be much more interesting, but cant be considered by this fund. Further, the manager may affect the price by moving a sizeable weighting. It is no surprise that hedge funds and the like know where the likely changes are taking place and can affect the share price if a longer-term manager is looking to exit or enter a big holding.

There is a limit to a managers assets. Once large, the process of creating the portfolio should change. It is more likely to replicate a cheaper exchange-traded fund or be handicapped by what it can achieve. This applies across the board, from big cap vanilla manager to the exotic small cap end. The question of liquidity of the investable universe, the maximum size of the fund and the attitude of the management team are just as relevant as their abilities to judge a companys merits.

Giselle Roux is chief investment officer at Escala Partners.

Excerpt from:
Look beyond performance when it comes to equity managers - The Australian Financial Review