Too big not to fail?

Mid-year 2011

When you are small, you want to be bigger.  In most endeavors being bigger is an advantage, but as those who grow large find, there are also disadvantages.   Just ask the seven foot tall basketball player or the 300 pound football player and I am sure they can give you both sides of the story.  In the world of investment management, the same holds true.

How much money can be managed in the strategy before returns are overly impacted by trading costs is usually the first concern for those evaluating equity managers?  It is a valid concern but, depending upon the strategy, the issue of liquidity is generally manageable.  Value investors who buy when everyone is scared and sell when they are jubilant find there is generally plenty of volume available at the extremes.  The bigger concerns aren’t quite so easily identified.  Recently, several events have caught our eye and provide telling case studies of how size impacts investing operations.

Let’s start with PIMCO.  They are a great fixed income manager and their acumen and creativity has enabled them to grow their assets under management (AUM) to $1.2 trillion(a).  That’s a lot of money.  So it leaves us puzzled as to why Bill Gross and gang seem to always be on TV, why they need to roll out a derivative light Total Return Fund, why they are rolling out an actively managed ETF and, most of all, why are they bothering to start up an equity business (for the second time)?   The continued focus on growth may be out of necessity and fear.  The parent, Allianz, surely wants the growth, but beyond that PIMCO has built a support staff of 2000(a) or so employees.  After a thirty year bull market in bonds they may be concerned the future for bond investors may not be favorable and a reduction in AUM may make it hard to cover the overhead.  Diversifying into equities could be one way to mitigate this business risk.  Seems to be a prudent business strategy for an asset gatherer, but it worries us that business concerns may be overriding sound investment thought.

The phrase “stick to your knitting” derives from the reality that people and organizations can generally do one thing very well and they should “stick to it”.  Consultants are very aware of its applicability to investment management and are generally on guard against process drift of any kind.  Yet rapid growth of assets under management often leads managers to try some things they may not normally have attempted.  A case in point would be the very public battle Fairholme Fund manager Bruce Berkowitz has had with David Einhorn of Greenlight Capital and the activist stance he seemed to be forced into taking.  How would Berkowitz have reacted if he wasn’t the largest holder of St. Joe or if he wasn’t defending his status as Morningstar fund manager of the decade?  In any event it appears to be new ground for him as evidenced by the awkward situation that developed and the ensuing SEC probe.  Einhorn, in this case, appears to be sticking to what he does best but we wonder if the fame and fortune that led to his bid for the New York Met’s baseball team may indicate a shift in his focus.

Finally, with size and success comes attention.  Paulson & Co. scored big by shorting subprime mortgages and financial stocks prior to the 2008 financial markets meltdown, enabling him to create new funds and grow his assets under management.  Accordingly, everyone wants to know what the “smart money” is doing.  And when the “smart money” gets burned in a Chinese stock like Sino Forest it becomes front page news.  Now we don’t know if Sino Forest will turn out to be a fraud or a good investment, but that’s not the point.  What’s important is to recognize that Paulson’s decision on how to handle his investment in Sino Forest had to be influenced by outside forces and the outcome likely was worsened because he was a big visible target.  At some point the pain of answering questions about Sino Forest was too great and the easiest way out was to sell.  How this experience will alter future decision making can’t be known.

As an investor the one thing you can be sure of is that you will eventually be wrong.  Successful investors excel by minimizing the impact of their bad decisions.  And as the examples we selected above show, size and notoriety can impact the investment process by introducing unanticipated factors into the equation that cause managers to stretch beyond their normal circle of competency thereby increasing their probability of making bad decisions.  The principals of LindeHansen experienced first-hand the issues that come with rapid growth and a large asset base at their previous place of employment.  We believe we understand what we can do well and intend on staying at a size and in a structure where our investment decisions will not be influenced by exogenous issues.  For those searching for an external manager, be wary: while hiring a large name-brand manager may seem like a lower risk proposition, we think it can come with an expanded set of risks.  At a certain level of AUM the advantages of size may accrue to the owner of the investment manager at the expense of client.

The material provided herein has been provided by Linde Hansen & Co. and is for informational purposes only. Linde Hansen & Co. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Linde Hansen & Co. are not affiliated entities. 0362-NLD-3/9/2012