Don Hamson Head of Active Australian Equities

CapacityWhen is enough, enough?

Australian Equities Managers Assets Under Management

As at June 30, 2004

Source: InvestorInfo Limited

0

5,000

10,000

15,000

20,000

25,000

1 4 7 10 13 16 19 22 25 28 31 34 37 40

0%

20%

40%

60%

80%

100%

120%

AUM Managed

Advantages and Disadvantages of large AUM

Advantages of being large

Economies of scale in research capabilities

Leverage over fixed costs of trading

Greater voice with companies

Disadvantages

Increased trading costs

Loss of anonymity

Limits to the size of holdings

Australian Corporations Law requirements

Section 671B(1A) – Substantial Holding

Statement at 5% voting capital

And from then every 1% movement

Section 606 – Prohibition on acquisitions

Cannot acquire >20% issued capital

Unless satisfy an exception, one of which is launch a takeover offer

Regulatory Impacts on Strategy Assets Under Management

Strategy Assets under management

1% = 5% at company number

1% = 20% at company number

$500m 199 n/a

$1,000m 192 n/a

$5,000m 110 188

$10,000m 71 148

$15,000m 57 124

$20,000m 45 111

Possible impact of regulatory requirements

Substantial shareholding reveals signal

Rest of the market may “front run”

No academic evidence as yet

Getting in is easy. Getting out on the other hand…

Overhanging stock

Trading costs

Brokerage – possibly decrease with volume

Bid/Ask spread – increase with volume

Market impact – increase with volume

AUM 1% tradeTime to trade

BHPTime to trade

CGF

$1b $10m ~20 min 3 days

$10b $100m 3.5 hrs 1 month

Note: Assumes 100% of traded volume. If only 20% multiply time to trade by 5.

Days to trade a 1% position

0

50

100

150

200

250

300

BHPAM

PW

ESPBL

JHX

TCLO

STBBG

NFDCG

FG

NSNUF

VRLPARCD

TAPAIX

FWD

GAS

HIL

AUM = $1b AUM = $10b

Source: IRESS

Cheap toTrade

Expensive toTrade

Cost increase

s as AUM

increases

What do managers do as they get bigger?

Trade less

Trade at a slower rate

Take smaller relative positions

Limit the total positions to <5% or <20%

Result

Reduces information ratio, active risk or both

Determining capacity

No fixed method for determining strategy capacity

Two possible definitions

Return based

Wealth based

Definition 1

Capacity is the strategy assets under management at which net alpha is at a maximum.

Net alpha = Gross alpha – Trading Costs

Gross alpha is the “on paper” performance potential

Example

Investment strategy

Gross alpha = 3% per annum (on paper)

Turnover = 65% per annum

Trade monthly

Trading cost model

0.20%, plus

Additional 0.20% for every $1b of annual trading volume

Trading costs increase as Strategy AUM increases

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

500

2,00

0

3,50

0

5,00

0

6,50

0

8,00

0

9,50

0

11,0

00

12,5

00

14,0

00

15,5

00

17,0

00

18,5

00

20,0

00

Assets Under Management

Po

rtfo

lio C

ost

of

Tra

din

g

Annual Turnover = 65%

Monthly trading - $27m

Monthly trading - $1,083m

Source: SSgA

Performance declines as Strategy AUM increases

-1.00%

-0.50%

0.00%

0.50%

1.00%1.50%

2.00%

2.50%

3.00%

3.50%

4.00%50

0

2,00

0

3,50

0

5,00

0

6,50

0

8,00

0

9,50

0

11,0

00

12,5

00

14,0

00

15,5

00

17,0

00

18,5

00

20,0

00

Assets Under Management ($m)

Per

form

ance

(%

pa)

Breakeven

1. Gross Alpha

2. Trading Costs

3. Net Alpha

Source: SSgA

Impact of Strategy AUM on Performance

Costs increase with turnover and AUM

Dependent on the underlying market

Performance impact is one way

Always reduces return

Breakeven point

Beyond which net return is negative

Definition 1: Optimal Capacity

Optimal solution

Don’t manage any assets

Investor perspective

Discourage manager from taking on too many assets

Small assets = Best returns

But Alpha Research Resources Revenue

What fee would a manager charge

Only hire small managers

A large number of small managers

Diversification problems

Identifying enough skillful managers

Definition 2

Capacity is the strategy assets under management at which wealth creation is at a maximum

Wealth = Net Alpha x AUM

Example:

Wealth Created = 2.5% x $1,000b

= $25m

Wealth changes as Strategy AUM increases

-150.0

-100.0

-50.0

0.0

50.0

100.0

150.050

0

2,00

0

3,50

0

5,00

0

6,50

0

8,00

0

9,50

0

11,0

00

12,5

00

14,0

00

15,5

00

17,0

00

18,5

00

20,0

00

Assets Under Management

Wea

lth

Cre

ated

($)

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Net A

lph

a

Adapted from: Perold, A.F. and Salomon, R.S., The Right Amount of Assets Under Management, Financial Analysts Journal, May-June 1991

WealthMaximising

AUM

Definition 2: Optimal Capacity

Optimal solution

The point at which the wealth creation potential of a strategy is at a maximum

This doesn’t mean that performance is at a maximum

Early investors get the good returns

Performance is diluted at the margin

Conflicting interests between manager and investor

Management fees of 0.30%pa

-250.0

-200.0

-150.0

-100.0

-50.0

0.0

50.0

100.0

150.050

0

2,00

0

3,50

0

5,00

0

6,50

0

8,00

0

9,50

0

11,0

00

12,5

00

14,0

00

15,5

00

17,0

00

18,5

00

20,0

00

Assets Under Management

Wea

lth

Cre

ated

($)

Investor wealth

Manager wealth

Source: SSgA

Performance fees help to align the interests

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.050

0

2,00

0

3,50

0

5,00

0

6,50

0

8,00

0

9,50

0

11,0

00

12,5

00

14,0

00

15,5

00

17,0

00

18,5

00

20,0

00

Assets Under Management

Wea

lth

Cre

ated

($)

Manager wealthwith fixed fees

Manager wealthwith performance fees

Source: SSgA

Performance fee = 20% positive performance

Capacity?

Definition 1

Stay small to keep return

Definition 2

Grow to wealth maximising point

Solution

Somewhere in between

Investor responses to the capacity problem

Demand an analysis of capacity

Implement monitoring procedures for process capacity

Beware the double count

Align interest

Performance fees

Still requires monitoring

The ultimate sanction

The “double count”

Problem

Make a nominal change to the process and call it a different strategy

Determine capacity for the two strategies separately

Solution

Capacity is specific to a set of alphas

Different versions may have different capacity impacts

“Double count” example

SSgA Active Australian equities

Single set of alphas

Multiple strategy versions

Strategy version AUM Capacity impact Capacity take up

Enhanced 500 0.25:1 125

Long only 1,500 1:1 1,500

Alpha Plus 1,000 2:1 2,000

Long/Short 350 3:1 1,050

2,350 4,675

How can a manager increase capacity?

All other things being equal

Lower turnover increases capacity

But alpha potential maybe related to turnover

Greater alpha increases capacity

Research effort

Lower transaction costs increases capacity

Need for skillful trading

Increase in market liquidity increases capacity

Need for regular review

Capacity: When is enough, enough?

Increasing AUM reduces performance

Investor and manager incentives may not be aligned

Need to monitor capacity and its impact

Performance fees can help align investor/manager

interests