As fund selectors, we spend a lot of time thinking about an investment proposition’s capacity.
The concept of capacity encapsulates the notion that the cost of implementing an investment strategy increases as assets under management (AUM) increase, and that performance is negatively affected as a result.
It reflects the fact that there are diseconomies of scale when it comes to investing, and that factors such as liquidity and ownership limits constrain a strategy’s ability to add value as assets rise. Many studies have confirmed that this contention holds.
Clearly, investors would prefer lower levels of AUM on the basis of this premise. However, investment managers have businesses to run, so an equilibrium asset level has to be reached at which the investor is delivered a good level of alpha and the manager has the opportunity to build a profitable business.
This will be a function of the asset class in which the strategy invests; the parameters within which the manager constructs his portfolio; and the strategy’s risk and return objectives. Capacity is reached when incremental AUM would stop the strategy from meeting its objectives.
In addition to market factors such as liquidity and breadth of opportunity, and portfolio factors such as ownership levels and risk parameters, a number of elements should be considered when assessing capacity.
A broad definition of AUM should be used, including those assets owned in other, related strategies, to assess the impact of competition for capacity from other products.
Furthermore, assets should be viewed in the context of the investable universe, not merely total market cap. The impact of investment style on investability should also be factored in, to reduce the risk of overexuberance when that style has been in favour.
Additionally, firms should build in room for asset growth that is attributable to the alpha that will be generated. If this is not taken into account, then alpha generation will eat into itself even when capacity is well-managed.
Investors can look for a number of tell-tale signs to tell whether capacity has been exceeded. The time taken to invest/disinvest assets will often rise, the number of holdings in a portfolio might increase, style drift may be exhibited (with holdings becoming more liquid or larger cap), transaction costs will go up, or turnover may fall.
Investors should ask managers to illustrate these characteristics to determine trends over time.
The burden of proof is with managers – if they do not measure the impact of capacity constraints, they cannot be sure those constraints are not hurting.
Finally, it is important to recognise that there are many factors and assumptions that have an impact on the calculation of a strategy’s capacity, and it is therefore important to be flexible when applying the concept. Assessing capacity is an art rather than a science.
That said, products often exceed their stated capacity by a wide margin (it can take a while to rein in the distribution effort when performance is strong and an asset class is in favour).
In such cases, the benefit of the doubt should not be given and it might be time to move your assets elsewhere.
Rob Hall is head of multi-manager at Schroder Investment Management
