Fine Print Focus: Capacity - Bigger is rarely better

Tuesday 6 March, 2018

Fine Print Focus: Capacity - Bigger is rarely better

Written by Paul Gregory, Head of Investments

Our clients and anyone who looks at our website knows that better-than-average performance is a core focus for Pie. It’s also clear that we want to extract much of that outperformance from growth companies which, typically but not exclusively, are smaller companies.

Many of our clients like to ‘look under the hood’ of our investment performance, to better understand our investment process. An important part of our process and performance is capacity, but it is not often well-explained – to the extent it is explained at all – by investment managers. 

Steering different loads

Capacity improves your ability to profitably launch, adjust and exit your investment ideas. Simply, capacity is about the amount of money which can be invested in an actively managed investment strategy, without harming its returns*. Capacity is particularly important when an active manager is trying to outperform in a small, illiquid market – like New Zealand’s share market. Or, when the active manager is trying to outperform in less liquid asset classes – like small-cap equities. Both aspects are relevant, to differing extents, to all of Pie’s funds. Which makes capacity important to all our clients.

Large capacity 

The more money invested in an active strategy, the larger the size of the positions. Particularly if you have a more concentrated approach, as Pie does. Big positions mean big moves in your chosen markets to initiate, build, reduce and exit your ideas. Big moves in equities can be expensive. First, because they cost more transaction fees. More fundamentally, because their size shifts the market in the equity, because they take time to complete, or both. In each case, the market price can move in an unhelpful direction – typically, up when buying and down selling. This reduces or even erases the return you’re trying to get. 

Think of it like trying to launch, or change the direction of a ship. The larger it is, the longer it takes... 

... Particularly if the water is shallow, which can mean some moves are just not wise or even possible. So, your options are limited and you’re less effective. 

Size mans the ship 

Having more assets under management certainly generates more fees. But if it harms returns, then the manager and the investor’s interests are not aligned. The manager is more interested in fee revenue than returns (and, perhaps, more interested in active-management-sized fees than actual active management). In those cases, investors should be looking for other active management options. Or even a passive manager delivering the same result – no outperformance – for less cost. Note Pie’s Australasian funds are soft-closed.

Capacity provides insight to alignment of interest. We should be paddling together.

Size of assets under management is the main but not the only influence on capacity. Changes in market liquidity – when more or less people than usual are buying and selling – improve or reduce capacity. The manager’s specific style also affects how much they can efficiently trade. 

Quality over quantity 

For Pie, capacity boils down to us knowing we must continue to keep our fund sizes small, to be able to deliver strong performance to clients. For clients, hopefully this discussion of capacity helps you to better understand an important part of our investment process. And gives you a tool for looking at investment management more broadly. 

 

*For a New Zealand-specific, more detailed explanation, see ‘Assessing Manager Capacity – the Case of New Zealand Equities’ at https://www.nzsuperfund.co.nz/sites/default/files/documents-sys/White%20Paper-Assessing%20Manager%20Capacity.pdf