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Aon Retirement and Investment Blog

Capacity Management: To close, or not to close, that is the question

Capacity management for equity strategies is a crucial element of evaluating not only how an investment manager plans to manage its overall business, but the impact it might have on potential value added for a strategy versus its benchmark and peers. Capacity management practices can differ noticeably across investment managers and the total estimated capacity will heavily depend upon the size and characteristics of the strategy’s investment universe and the type of investment strategy employed. The estimated total capacity for a strategy is likely to be dynamic and vary according to market conditions. We believe that the primary role of capacity management for a manager is to determine the threshold of assets under management (AUM) where the ability to execute its preferred investment approach is not significantly sacrificed. Furthermore, a manager’s stated capacity level can provide an indication of the business’s focus on its profitability versus client performance.

What characteristics are considered in a capacity management analysis?
Typical capacity management analysis conducted by managers may include an analysis of the following: 

  • The overall liquidity of its portfolio. (i.e., how many days would it take to liquidate the entire portfolio, and what percent of the average daily trading volume does each stock represent) Many managers do not want the total value of any of its holdings to be greater than 20% to 25% of the total value traded over  30- to 90-day rolling periods.
  • The percentage of ownership of the outstanding shares of a company at the product and firm level. Most managers will limit themselves to owning no more than 10% to 15% of the outstanding shares of a company. This guideline is typically utilized in multi-product firms, particularly large investment management firms, which have overlap in investment approaches where commingling the total exposure to one security is necessary. Additional SEC filings are required once a manager owns greater than 10% of a US-listed company’s outstanding shares. The higher percentage ownership of a company that a manager owns may lead to possible negative consequences (e.g., it can cause liquidity issues or impact the stock price more than intended when the manager trades in the name).     
  • Ability to manage net asset flows. (i.e., the manager’s ability to invest inflows and manage outflows without impacting performance negatively).
  • The asset size of their strategy versus the size of the overall market or investable universe. (e.g., a $3 billion international small cap portfolio is approximately 1.6% of the $1.9 trillion market capitalization of the MSCI EAFE Small Cap Index[1]) Some managers may estimate capacity as a percentage level of the total market capitalization of their respective space such as 1.0% or 2.0%. 
Additionally, other factors may impact capacity such as the total number of portfolio holdings and the type of investment approach a manager utilizes. Concentrated equity portfolios of 30 to 50 stocks, as an example, can have less than half of the total capacity relative to diversified portfolios of greater than 100 stocks. Furthermore, quantitative equity strategies generally invest in a large number of stocks (e.g., several hundred or even thousands of stocks) to help them exploit various factors in their models. This may increase total capacity relative to an approach utilized by a traditional fundamental equity manager, but the higher level of turnover usually required by these strategies offsets this to some extent.

Once a certain asset threshold is targeted and met, managers may choose to either soft or hard close the strategy to investors. A soft close occurs when a manager no longer allows new investors into a strategy, but it will still allow existing investors to continue allocating assets, whereas a hard close prevents any investor from investing further. Soft closing is a more common practice and managers who hard close a strategy may experience client terminations since it forces clients with growing asset bases to either add another manager or replace the manager with a new one that is open to investors.

Why Capacity Management Matters
There are positive and negative effects to managers who have been successful and gained a meaningful amount of assets. Assets under management (AUM) levels can be crucial to gauging a manager’s ability to achieve its performance expectations. While having a larger AUM base enables a manager to invest in resources, such as additional investment staff and/or technology, to support the success of its strategies, it can also detract from a manager’s ability to remain aligned with its stated investment philosophy and approach. We have found that a higher asset base, especially if above the strategy’s capacity, may:
  • Have a negative impact on future performance versus firms with a lower asset base[2]
  • Possibly create liquidity issues with holdings that have lower average trading volumes or where they are a large owner of the outstanding shares of a company
  • Lead to lower levels of active share (i.e., how different the portfolio is from its stated benchmark --we have found this more common with products that have a larger cap focus than a smaller cap focus[3])
  • Limit a strategy’s position sizing (e.g., the ability to build a larger stock weight in a portfolio may not be possible due to liquidity issues and share ownership limitations)
Some characteristics of managers approaching estimated capacity levels yet not choosing to limit the amount of assets it manages may include adding more staff to a strategy, increasing the number of allowable holdings, and/or modifying the strategy’s investment characteristics. All of these are tactics to allow a manager to accept new assets when the strategy has already become too large to manage. When products with large assets remain open to all investors, it is likely that continued asset growth was the main business priority versus  future investment performance considerations.
We expect best in class managers to have robust capacity management practices in place as well as histories of actually closing strategies. Moreover, we prefer for managers to adhere to the stated capacity goals and communicate any changes to its policies in a timely manner as it could affect future performance and client usage.

Corey Schier is a Senior Consultant in Aon Hewitt’s Equity research team working out of the Atlanta office.

[1] Source: MSCI.com and data as of 30 October 2015.
[2] Source: Aon Hewitt and data provided by eVestment. Analysis shows for active equity universes that manager excess returns decrease at higher levels of assets under management. The regression analysis from creating scatterplots of three-year excess returns versus assets under management levels over several different time periods produces negative to slightly negative slopes for most of the equity universes analyzed including U.S. Large Cap, U.S. Small Cap, Global, Non-U.S., and Emerging Markets Equity. The data was more pronounced prior to the liquidity driven markets of the past five years.
[3] Source: Aon Hewitt and data provided by eVestment. Analysis shows that for the actively managed investment managers with greater than $25 billion in assets within the eVestment U.S. Large Cap Equity Universe, who actually reported active share, have an average active share of 70.8% versus 76.3% for the managers with less than $25 billion in assets. The numbers are evident as well for the actively managed investment managers within the eVestment Emerging Markets Large Cap Equity Universe where the managers who have greater than $10 billion in assets have an average active share of 71.7% versus 81.2% for the managers with less than $10 billion in assets. 
The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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