At Shoreline we believe that every active equity strategy has its own capacity limit. As FUM grows, an investment managers ability to deliver outperformance for investors can slowly decay. We have all witnessed small investment managers struggle to repeat their success as funds under management grows.
The amount of alpha that can be generated can be impacted by the size of assets managed by a manager. Increasing transaction costs including market impact costs is one of the main reasons that maintaining high performance as FUM grows becomes difficult and eventually impossible. The total cost of executing an investment decision covers both explicit trading costs, such as brokerage and taxes, and implicit costs such as market impact and opportunity costs.
In an increasingly regulated business environment a very low level of FUM poses various investment challenges and managers therefore actively seek to grow FUM and attain the benefits of a larger fund. However, managing a significant percentage of the market’s capitalization can make alpha more difficult to generate. Thus, investment managers must understand at what point they must stop growing FUM so as not to inhibit their ability to meet performance targets.
Different definitions are sometimes used in financial literature when referring to the ‘capacity limit’ of an active equity strategy. We like to define the capacity limit as the maximum level of assets at which the strategy can still be expected to achieve its performance targets.
The capacity limit for a particular manager will shift with changing market conditions and as portfolio characteristics and therefore capacity limits need to be regularly monitored. Irrespective of the manager’s decisions, capacity limits are liable to change over time, as market liquidity and depth, the two key market factors impacting investment returns, change.
Capacity limits can vary widely across two active equity managers in the same market. The manager directly affects capacity through their ability to generate alpha and trade efficiently. They also influence capacity through their decisions on portfolio design and constraints. This includes factors such as the style the manager employs (e.g. momentum vs. contrarian), concentration of the strategy, turnover, exposure allowances, tracking error limits and the defined investment universe.
Another point to note is that different active equity funds managed by an investment team can use up the total capacity limit of that investment team at different rates.
For example, index funds are typically excluded from total FUM in the assessment of the capacity of the manager’s overall active strategies. Assuming that the capacity limit estimated for a strategy is based on the manager’s flagship product, the FUM in lower turnover funds, such as low tracking error products, should be scaled down by an appropriate factor before being included in the manager’s total effective FUM for capacity assessments. Similarly, FUM in higher turnover or more concentrated products should be scaled up by an appropriate factor.
Managers must balance the significant competitive advantages from having a high level of FUM – greater resources, better systems, higher remuneration benefits, lower brokerage fees and better access to company management – with the additional costs, i.e. higher market impact and opportunity costs from trading, which can result in performance leakage.