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'.