A few months ago we wrote about strategy capacity, specifically, regarding the trend-following managed futures universe. In discussing the issue, we outlined that one of the most important exercises we go through when developing a strategy is to understand the markets we will be trading, the sources and nature of liquidity, and the potential for impacting prices when we trade if we raise significant assets within the strategy. While we were speaking in terms of trend-following strategies, the same lessons can be applied across the entire investment strategy spectrum.
Our process for establishing and updating capacity for any given strategy is the following:
- 1. Establish what instruments will be traded.
- 2. Conduct an analysis to develop a reasonable market-impact model (that will be updated as we begin to trade a strategy and/or receive more information regarding a market’s structure).
- 3. Determine the point at which our trading will have negative impact on a trading model’s outcome, effectively decaying alpha.
- 4. Build a portfolio that maximizes risk/return without sacrificing alpha due to market impact.
- 5. Determine an implied current capacity number based on this portfolio.
- 6. Trade the strategy, no matter its current size, as if it were at this capacity number (this keeps a strategy’s expected returns consistent over its lifetime).
- 7. Update the analysis periodically, as markets tend to change over time.
As a due diligence professional, it is always important to understand a strategy’s capacity limitations, and then to monitor the strategy against those assumed limitations over time. In the mutual fund space, this may be one of the most important aspects of ongoing due diligence an investor can conduct, especially for successful funds that have garnered significant assets due to strong performance, as they are unlikely to be raising other red flags. The following are some recommendations for monitoring capacity across investment strategies:
- 1. Find out what the firm believes their capacity is before you invest. Ask how they arrived at this amount and understand what factors could cause the number to change.
- 2. Continue to address capacity in ongoing due diligence, especially for strategies with strong performance and asset growth.
- 3. As a fund’s AUM grows, monitor performance for any apparent changes in strategy, such as unexpected behavior during changing market environments (e.g., is the fund acting different than it has in the past—more volatile or less volatile? etc.).
Success can generate greed, and greed can kill future returns. Investors must continually monitor their investments’ true capacities and be willing to act if a manager appears to have breached that level. Often, this makes for the behaviorally difficult act of selling managers with strong performance, but it can save you from seeing the excess gains earned over time revert back to merely mediocre performance or worse.