Rewind a decade and any fund over £1 billion was considered big news, but today referring to them as ‘supertankers’ seems almost banal.
Indeed, the game has moved on as market capitalisation has grown multiple times and we have had to adjust what ‘big’ means.
Now the biggest home-grown strategies such as Standard Life Investments’ Global Absolute Returns Strategies (Gars) are north of £50 billion (across various markets), and even equity income strategies such as Neil Woodford’s peaked at over £35 billion before he announced his impending move to Oakley.
As a fund market we have never really got used to super-sized funds, yet in the last five years we have thrown our assets increasingly at a smaller number of funds.
Growing up in the 1970s, my father was an engineering officer in the Merchant Navy so I was used to various anecdotes about his life at sea and what supertanker leviathans were like to control.
He worked on the very largest supertankers of the day, known as ‘very’ and ‘ultra large crude carriers’ and supertankers have never been quite so large since.
I was reminded of his stories when I first started to use the term ‘supertanker fund’ to describe the rise of the many multi-billion funds (in excess of £5 billion or even £10 billion) that have become commonplace today.
If we liken funds to ships, then the largest would most certainly resemble the largest supertankers or crude carriers. If this analogy holds, then the biggest risk for these funds is ‘draft’ and ‘shallow water’. Let me explain.
Draft is the naval term for how deep a ship’s hull sits in the water. When supertankers are fully laden they sit very deep in the water and draft creates drag which has a bearing on how ships handle in different depths of water. Supertankers have long struggled with navigating shallow water, especially when carrying large loads.
The main problem is one of size as supertankers were built with cost rather than nimbleness in mind.
Supertankers tended to ‘yaw’ rather than steer like conventional ships. This is when the entire body of the ship moves sidewards, with the rear often adopting an attitude angle greater than the front of the ship as it tries to turn. In investment terms, this would be similar to when a huge fund tries to dump a large amount of its assets into the market through program trades.
As the fund exerts a large impact on the trading volume (and hence price), then the order book moves around the fund as much as the fund is able to get in and out of the market.
Quite often there are insufficient participants to trade the other side of the book with the fund manager. The manager is then forced to trade out/in progressively and thus has to accept the shifting price (‘yaw’) on day three in response to his trading on day one.
Many harbours in the 1970s could not accommodate these leviathans and if you look at the size of some funds and the markets they operate in, the lure to compare the depth of liquidity and water is tempting.
The effects of shallow water
We have seen banks reducing their proprietary trading to meet new regulation and capital controls. This suddenly removed some of the largest market-makers and anecdotally, is causing liquidity tightening in various markets, such as in bonds (according to fund managers) but the evidence isn’t cohesive yet.
I believe we are in a similar position with mutual funds today. When does navigating market liquidity become too onerous with growing capacity; when is big too big?
Moving in shallow water causes handling issues. Ships have greater inertia in shallower water, so are less responsive to changes in speed and course. As speed is reduced, so too is steering control, meaning the pilot has to be prepared to make prudent compromises.
It is therefore logical that supertanker funds can navigate larger, more liquid markets more easily than smaller, less liquid ones. This point has been put into focus by the unlisted microcap positions in Woodford’s Income and High Income funds, which his replacement, Mark Barnett, will have to endeavour to trade out of at some point.
On larger funds, where the trading ability of the manager is slow compared to the volume of assets required to be traded, this can have a significant bearing on tactical asset allocation decisions.
By owning so much of the market, a supertanker fund may become susceptible to unexpected ‘beta’ shocks as the trading volume around its positions becomes shallow and therefore even small volumes of trade can have a disproportionate impact on the price of its holdings.
Imagine if two or more supertankers funds attempted to trade at the same time and in the same direction, then the issue becomes quickly exacerbated. It has already been reported that supersized high frequency trading funds have helped to create ‘flash crashes’ when they have come into contact with one another. This can happen rapidly and without warning and be exacerbated if there is a sudden rush of redemptions. If the fund manager is unable to cover all redemptions out of his/her ‘box’, the fund could struggle to find the necessary number of buyers at an optimum price.
These issues can and do lay dormant for months or even years so long as the market direction remains relatively straight-ahead. When markets become stressed and we see investor herding and asset rotations, then these issues can suddenly emerge. Large assets can provide economies of scale but can pose difficulties when navigating difficult markets.
The key question here is how effectively can a manager handle the capacity of this supertanker fund? As fund sizes grow, we should take liquidity management and capacity much more seriously before investing in such funds.
We must ask the simple questions: how diversified is the fund by geography of issue and asset class invested, how liquid are those positions, what is the maturity profile of those assets and what does the fund’s liquidity management look like?
If you find you are not fully comfortable with these questions – or the resulting answers – then pause before weighing anchor.