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Too big to perform? The importance of limiting capacity

“Anyone who says that size does not hurt investment performance is selling. It’s a huge structural advantage not to have a lot of money.”

That quote is from legendary investor, Warren Buffett, who highlighted an investment truth: big isn’t always best when it comes to investing.

There is a clear inverse relationship between a portfolio’s size and its ability to generate alpha. The investment landscape is littered with managers, unable to resist the lure of higher fees from larger pools of money, whose returns slumped when they got too big.

So, while equity portfolio managers track hundreds of companies to find winning companies, they also need to closely monitor the size and liquidity of their portfolios. Indeed, we believe that answering the crucial question of where a fund’s capacity level sits, and sticking to it, is a vital source of investment edge.

Spooked by icebergs

Capacity is an important but often ill-defined concept. It relates to how much money can be invested in an actively-managed strategy without harming that strategy’s future returns.

When an investment manager has smaller pools of money, they can rotate between stocks quickly, and with minimal pricing impacts. But once a fund grows its funds under management (FUM) beyond a certain amount — beyond its capacity — it is harder for the manager build meaningful positions in stocks.

Large FUM also makes it harder to exit stocks quickly to avoid ‘icebergs’. The manager of big money has to move very early to avoid an iceberg. But that comes at a price, as some of those risks won’t play out. By moving early, the manager unnecessarily wastes time and money in transaction and market movement costs to the detriment of investors.

Multiple channels of constraints

Capacity constraints on a portfolio come through multiple channels:

  1. Constraints on portfolio positions – These relate to limits on portfolio weights. They might include maximum stock, sector or geographic weights, both in absolute terms or versus their relative weights in the benchmark index for the fund. For example, an investor may not wish to hold more than 10% of the portfolio in one single company, thereby limiting how difficult it is to exit a concentrated position.
  2. Constraints on company holdings – These relate to how much of the company’s shares on issue you wish to own. An investor might have a limit on holding no more than 5% of market capitalisation or value of any company.
  3. Constraints on trading – These relate to expected limits on the physical ability to trade. Investors may not, for example, wish to participate when their share of the average daily volume traded of the company is above 30%, because being above that threshold is likely to incur material market movement costs. Another trading constraint might be that at that trading level (30% of daily volume), the investor would not own positions in companies they could not exit within some defined period, say a week or a month.

Establishing capacity

Academic studies have found that increases in FUM for a fund manager are associated with less alpha generation (benchmark outperformance) and reduced absolute levels of investment performance.

But there is no precise way to measure where a fund’s capacity sits.

Capacity is fluid and influenced by numerous market dynamics at any given time. Capacity estimates, therefore, are best evaluated using judgement and a range of perspectives, and not fixed forever in dollar terms.

A bottom-up aggregation, from an individual stock to a portfolio level, is one guide to estimate a fund’s capacity threshold. For example, assume we have a 30-stock small cap fund where the average company in its investable universe has a market cap of say $1.0 billion. We can also assume that many funds avoid owning more than 5% of a company because crossing this threshold can lead to a significant increase in regulatory issues. Based on these inputs, we can assign that fund’s theoretical capacity at $1.5 billion ($1.0 billion x 5% x 30 stocks).

But even outside of these mathematical constraints, we know that being large can hurt returns. You may identify a stock opportunity with 20% upside, but by moving all your money in and establishing that position you raise the price 10%, limiting potential returns.

So, performance-focused managers will put investors first and strictly limit capacity. They will close their fund to new capital or even sometimes return capital to fund holders. They will resist the lure of letting their funds grow too large so they can earn higher base management fees

An enduring competitive advantage

When investing in the smaller and less liquid stocks on the market, capacity considerations are further magnified. For example, we decided in early 2018 to cease taking additional investments into the Ophir High Conviction Fund (ASX:OPH). Similarly, we closed our original fund, the Ophir Opportunities Fund, to additional investments back in 2015.

We had decided that after less than three years of operation these funds had reached their capacity level. We wanted to ensure the underlying investment strategy could continue to take full advantage of attractive investment opportunities.

A consequence of capping the size of an open-ended fund, is that new investors may feel unable to gain exposure to our fund’s strategy. Existing investors could be similarly frustrated if they want to increase their exposure. By listing OPH on the ASX as a closed-end vehicle, however, investors are free to buy and sell the fund with the same level of freedom and flexibility as they would with any company listed on the market.

Ultimately, we believe that by keeping the size of our funds well within their capacity limits, our team is best placed to generate strong investment returns for our investors. We see these strict capacity limits for our strategies as an important asset for us and it will remain a competitive advantage against peers that cannot resist the temptation of 'getting big'.

 

Andrew Mitchell is Senior Portfolio Manager and Co-Founder at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

 

4 Comments
Graeme
October 08, 2020

I find it odd that Ophir closed one fund due to capacity constraints at about the same time as it opened a similar fund. By this logic there is no capacity limit if one just keeps opening more funds. Surely it is the total dollars a manager has to invest in a sector of the market that ultimately limits capacity, not how much each individual fund has to invest.

Luke McMillan
October 09, 2020

Hi Graeme, thanks for your question. You are right that is the total dollars a manager has invested in a sector that is relevant for capacity.

I assume you are referring to our two Australian equity funds, the Ophir Opportunities Fund and Ophir High Conviction Fund. The former is a small cap fund and the latter is more a mid-cap fund. For example the weighted average market cap of companies in the Ophir Opportunities Fund has historically been around $1.5bil whereas it has been around $6bil for the High Conviction Fund. In the High Conviction Fund about 80% of the allocation is in companies with a larger market cap than the typical weighted average market cap of the Ophir Opportunities Fund. Given this much of the funds are operating in different parts of the Australian equity market which have different capacities.

At around $300m in the Australian small cap strategy and $900m in the more mid cap focussed strategy these amounts are significantly smaller than the larger peers in the market. I hope this clears things up.

SMSF Trustee
October 08, 2020

Intuitively sounds correct, but has anyone done any empirical research? Is there any correlation at all between performance and fund size? It might be just 'marketing' for a large fund manager to say that 'size doesn't matter', but it could also be just marketing for a small fund manager to say 'size does matter'.

Large managers do have the advantage of lower fixed overhead costs per dollar invested and thus the potential to charge lower fees than small managers. I'm pretty sure there's a correlation there, too! Small fund nimbleness doesn't come cheap.

Alex
October 08, 2020

It's good to see someone take a stance on this. It's not only capacity of the particular market, but the limits to the 'good ideas' a fund manager has. In my experience, a fund manager might have 20 stocks they really like, but as the money flows in, they expand this to 30 and 40 and 50 and then index performance follows as they protect the business.

 

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