Diseconomies of Scale

Investing might be one of the few environments where participants can easily experience diseconomies of scale. In other words, bigger is not better. Specifically, small hedge funds and, when they're knowledgeable and have adequate resources, individual investors, can often put up better returns than the multi-billion dollar behemoths. Evidence for this claim is mixed, but I believe that as time goes on and the big funds get bigger, we'll see some more proof of this claim.

Fundamentally, there's a very simple reason for this assertion: the bigger a fund gets, the smaller the pool of potential investments becomes. A $50 million fund has a very large pool of potential investments to choose from, the only restriction being securities reserved for QIBs and other high-net worth entities. On the other hand, a $10 billion fund can't realistically put money into, say, a stock with a $300 million market cap. The fund simply can't buy enough of the investment without significantly affecting that investment's price. Any investment the firm could make simply would't "move the needle" as far as returns go, and thus doesn't justify the time and effort of the fund's analysts.

Similarly, large banks and research firms on the street aren't interested in analyzing small securities because their clients, the big funds, can't or won't invest in them. Why do the work if you won't get paid for it? To focus specifically on the equity markets, (my primary area of expertise and interest,) small-cap stocks are generally neglected by the larger banks. Many companies are covered by only a handful of analysts, and quite a few are simply not covered at all.

There are currently over 5000 publicly traded companies in the US, (probably closer to 8000 if you include bulletin board stocks, the NASDAQ SmallCap Market, and various other less-liquid listings.) I'd guess that at least one third of these companies are severely under-followed, if even covered at all by any research firm or bank. That's a huge pool of potential investments that the banks won't cover and the funds won't trade. If even one half of one percent of them are mis-valued, that's approximately 12 securities you could potentially buy. Remember, according to modern portfolio theory, more than around 15 stocks in a portfolio and you're really not getting any marginal benefit.

What's important here is that the small guy can profit in areas where the big guys can't. My belief is that there are plenty more than just 12 mispriced names out there. Take a look at some of the blogs on the sidebar - the value investors out there focusing on small cap names seem to put up some pretty good returns. I'm not as knowledgeable as most of them (yet,) and I don't have quite as much time as they do to do the research, (CFA is still eating up all my free time,) but even I've found a few huge pricing errors over the past year or 2. People - the opportunities are out there. You just have to dig a little.