Independent financial advisers are required to consider the whole market of possible investments for clients in order to find the most suitable one. However, in practise many apply a number of filters in order to narrow the choice down from the thousands on offer.

These are used for a number of reasons, such as reducing risks, but it also shrinks the task to more manageable levels. Others may outsource the decision making process to third parties or just use the restricted approved list provided by their network to accommodate the increasing level of regulatory oversight. The compliance consequences for advisers of going outside these lists can act as a strong discouragement for going “off piste” and selecting something that is perhaps more interesting and offers more potential for good returns with an imaginative approach.

The most common filters can be size of fund and length of time it has been running as intermediaries can be wary of small funds and tend to recommend large ones that are better known. That is why the top ten funds accounted for 18% of gross retail sales in 2013. With such a concentration in the large funds it leaves less money available for the smaller funds and clearly works against new funds trying to break into the market.

Whilst there is an element of comfort to be gained from investing in a large fund, that is widely owned by others investors, they are not gaining exposure to innovative approaches.
Traditionally big funds invested in big stocks and small funds invested in small stocks. One argument for the disparity was that smaller funds could nimbly exploit the lack of liquidity in mid and small cap stocks and therefore operate in parts of the market that the leviathans could not. This flexibility offered the promise of better performance.

It is generally accepted that smaller stocks usually mean higher risk, particularly in relation to liquidity, but that is compensated by the potential for higher returns. It might be difficult for large funds, which normally have large minimum deal sizes, to invest substantial sums of money into smaller capitalisation stocks. The real problems though come when they need to get out in a hurry when sentiment changes. No wonder some professionals call them “lobster pot stocks”; hard to get into, impossible to get out…

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