Why “Bigger” Isn’t Better Liquidity in the Canadian Equity Market

When selecting a fund manager, one of the many factors investors evaluate is the amount of assets under management. The theory is that if it is a big fund (i.e. large amount of assets invested), it is likely a safer place to invest because the manager has been successful in growing assets. This theory may not be true if: 1) the fund has grown assets through skilled marketing or by acquiring other funds rather than through generating high returns; or 2) the growth of the fund has caused the portfolio manager to deviate from the investment style that originally made it successful. Why would a manager’s investment style change just because the assets under management have grown? The answer lies in understanding that as assets in a fund become very large, there are fewer stocks available for the manager to select. This is true because of the scarcity of stocks that trade with sufficient “liquidity” for very large portfolios.

We can illustrate this investment truth by analyzing the liquidity of Canadian stocks. For our purposes, “liquidity” is defined as the average dollar amount that a stock trades in a month, expressed in $ millions. The more a stock trades, the higher its liquidity, and the easier it is for a portfolio manager to buy or sell it without impacting the price.

Source: Morningstar Average Monthly Trading Volume in Canada Cumulative Distribution For example, only 119 of the nearly 700 stocks STYLUS monitors trade more than $150 million in market value each month This chart shows the number and percent of stocks monitored by STYLUS that trade above certain liquidity thresholds 100%

Some perspective… What is the availability of stocks for these large fund managers in Canada? Among the 40 largest Canadian mutual fund companies, the average assets under management invested in Canadian equities is approximately $5.0 billion 1. 1 The Investment Funds Institute of Canada

Average Monthly Trading Volume in Canada (Cumulative Distribution) Manager Size1% Holding3% Holding $20 billion$200 million$600 million $5 billion$50 million$150 million $1 billion$10 million$30 million $300 million$3 million$9 million $100 million$1 million$3 million For a manager with $5 billion under management, a 3% holding would equate to $150 million invested in a single stock. The universe of stocks available for a fund manager at this size is only 119 stocks!

Average Monthly Trading Volume in Canada (Cumulative Distribution) Manager Size1% Holding3% Holding $20 billion$200 million$600 million $5 billion$50 million$150 million $1 billion$10 million$30 million $300 million$3 million$9 million $100 million$1 million$3 million However, for a manager with $100 million under management, a 3% holding would equate to $3 million invested in a single stock. The universe of stocks available for a fund manager at this size is 544 stocks!

Observations: The larger the assets under management, the fewer stocks there are available that trade with sufficient liquidity. The more limited the investment choices for a portfolio manager, the more difficult it becomes for the manager to find stocks that meet his/her investment style. At STYLUS Asset Management, our goal is to earn superior returns for our clients by adhering to a disciplined management style. Placing a cap on the assets under our administration will help us achieve this goal since the larger pool of stocks from which we can choose will make it easier to select companies with strong fundamental characteristics. Can we actually prove this? Of course we can …

# of stocks with Price to Earnings Ratios better than the index average of 15.2x But the larger group of stocks that trade more than $3 million each month includes these 59 “cheap” stocks PLUS 157 more. Of the stocks that trade more than $150 million each month, there are currently only 59 that have “superior” price to earnings ratios (i.e. P/E less than the index average of 15.2x). With a smaller number of high liquidity stocks there are fewer stocks with superior characteristics: 59 stocks 157 more stocks (total = 216) Liquidity at least $150 million per month Liquidity at least $3 million per month Source: Morningstar Price to earnings is not the only fundamental factor where a lower liquidity threshold offers more choice…

# of Stocks with Characteristics Better than the Index These bars represent the number of high liquidity stocks with characteristics better than the index Compared to the high liquidity group, the lower liquidity group has a lot more stocks with superior characteristics. 157 more (total = 216) 215 more (total = 268) 144 more (total = 206) 154 more (total = 214) 201 more (total = 258) Low liquidity stocks (minimum monthly trading volume = $3 million High liquidity stocks (minimum monthly trading volume = $150 million Source: Morningstar

Conclusion: The larger the assets under management, the fewer stocks there are available to buy, and therefore, the more limited the investment choices for a portfolio manager. At STYLUS, we closely manage our assets under administration, which means we have a larger pool of stocks from which we can choose. Does this translate into better returns for our clients?

Performance as of May 31, 2013 Performance of the Momentum Composite from May 27, 2004 to present comprises the returns of the STYLUS Momentum fund. Performance prior to this date relates to a proprietary fund managed by STYLUS Asset Management Inc. (formerly C.P.M.S. Computerized Portfolio Management Services Inc.) and has been reduced to account for pro-forma management and performance fees. All other fund returns are shown net of all fees. STYLUS Momentum Jan 1, 1994

If you have any questions about the information that we have presented please do not hesitate to call: Brennan Carson Vice President, Client Service & Sales (416) , x.6