By Betsy Palmer
As assets under management grow, investment managers may find it increasingly difficult to execute their strategies effectively because of liquidity constraints and higher transaction costs. The common solution to capacity constraints is product closures, which are designed to protect the interests of existing clients by limiting further inflows. While there is general agreement among money managers that products need to be closed for capacity reasons, there is no consensus on how capacity should be measured.
Most investment professionals agree that there are capacity constraints on at least some investment styles.
A manager might be unable to buy certain stocks because of insufficient liquidity, resulting in opportunity cost. Higher transaction costs and opportunity costs might make it difficult for portfolio managers to realize their performance objectives.
Certain equity asset classes are more capacity constrained than others. Portfolios invested in large-cap U.S. equities have significantly more capacity than portfolios invested in, say, small-cap or emerging markets equities. Highly concentrated portfolios (e.g., portfolios of 20 stocks) generally have less capacity than more diversified portfolios.
The most common solution to this problem is product closures, which can protect the interests of existing clients by limiting further inflows. Product closures are typically either soft (e.g., further inflows are usually restricted to existing clients) or hard (no new assets are accepted into the strategy).
Several studies have presented ideas on capacity management. Andre Perold and Robert Salomon Jr. — in their paper "The Right Amount of Assets Under Management" in the Financial Analysts Journal, May/June 1991 — described a technique for measuring wealth maximization, defined as the point at which the amount of dollar return from an investment strategy is maximized. Marco Vangelisti — in his paper "The Capacity of an Equity Strategy" in The Journal of Portfolio Management, Winter 2006 — offers another alternative to capacity management using the concept of threshold capacity as the level of assets under management above which the client's return expectations can no longer be met. Peter Rathjens and Bruce Clarke, in a July 2005 paper — "Measuring Developed Market Capacity," available at Arrowstreet Capital LP's website — describe an approach to keep transaction costs low as assets grow by focusing on various trading techniques. And Angelo Lobosco of State Street Global Advisors has developed an approach to estimating capacity limits using the transfer coefficient, a measure of how much of the forecasted alpha is captured by the portfolio. He uses simulations at various levels of turnover and assets to balance the transfer coefficient's benefits with its associated trading costs.
Capacity metrics are highly sensitive to the inputs used. The liquidity of holdings in the portfolio when a test is performed, as well as the overall level of the market and market liquidity, will affect capacity. However, tests can vary assumptions across different types of products. Constraints applied to a large-cap U.S. equity portfolio might be very different from constraints applied to a small-cap international portfolio.
Among capacity tests, a shift upward in the market capitalization of portfolio holdings or lower portfolio turnover might be indicative of a change in style to accommodate large inflows. Of course, a change in style may not necessarily be motivated by asset growth. A larger-cap bent may be the result of better opportunity among large-cap stocks than among small-cap stocks. Similarly, lower turnover may be a reflection of lower marketplace volatility and commensurately fewer opportunities to add value by transacting. Nonetheless, capacity might need to be preserved to allow the flexibility to move the portfolio into smaller stocks or to allow for greater turnover.
Monitoring transaction costs provides an idea whether increasing assets under management increases the cost of implementing a strategy. Transaction costs can be compared with those of other managers on a variety of measures including volume-weighted average price.
A significant consideration of capacity is the constraint on portfolio managers' time. The institutional marketplace demands a significant time commitment by portfolio managers for a product that is experiencing rapid growth in assets. If the portfolio management team's time is not managed effectively, this could represent a significant capacity constraint.
Before recommending a portfolio manager, consultants — who drive the bulk of the institutional business — must thoroughly understand the investment philosophy and process and be comfortable with the portfolio management team. This evaluation might require several meetings between the portfolio management team and the consultant to have the product rated. Once the product receives a buy rating from the consultant, the money manager is invited to participate in final presentations, allowing the money manager to compete for a client's business with other money managers. After that, a client generally requires one to two meetings annually with the portfolio management team to keep apprised of portfolio positioning and performance. Therefore, each new client brings with them a stream of associated meetings.
The many meetings a portfolio manager might have to conduct with clients, consultants and new business prospects over time would potentially allow little time for doing anything else. Implementing product closures can certainly help to limit the drag on portfolio management time.
Product closings can protect client interests by ensuring that asset growth does not impede a manager's investment style. While there is no universal technique for measuring and monitoring capacity, it is critical for money managers to have methods compatible with their own investment approach to estimate capacity. Managers and clients alike would benefit from open discussion and sharing techniques for determining capacity constraints.
Betsy Palmer is director of global institutional product management at MFS Investment Management Inc., Boston.