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The Art & Science of Capacity Management

February 5, 2020

  • In the asset management industry, there is an inherent conflict of interest between asset managers and clients: greater AUM leads to higher revenue for the manager, but can negatively impact performance generated for existing clients.
  • As such, capacity discipline is a critical component of an active manager’s ability to add value for clients.
  • At Diamond Hill, we have been thoughtful and intentional about properly aligning our interests with those of our clients in order to ensure our portfolio managers are incentivized to add value for clients rather than gather assets.
  • Three primary factors in estimating a strategy’s capacity include: the ability to take a meaningful position across our full opportunity set, liquidity considerations, and our desire to continue as a long-term partner with existing clients.

For more details listen to our podcast featuring Bill Zox, CFA, and Chris Welch, CFA.


(disclosure)

The views expressed are those of Diamond Hill as of January 2020 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

The Russell 1000 Index is an unmanaged market capitalization-weighted index comprised of the largest 1,000 companies by market capitalization in the Russell 3000 Index, which is comprised of the 3,000 largest U.S. companies by total market capitalization. The ICE BofA U.S. High Yield Index tracks the performance of the U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. These indices do not incur fees and expenses (which would lower the return) and are not available for direct investment.

The value proposition of active managers rests on the idea that a consistent and repeatable investment process has the potential to outperform a passive alternative over the long term. At Diamond Hill, we seek to add value for our clients through a disciplined, intrinsic value-based approach, utilizing a long-term perspective and aligning our interests with those of our clients.

Alignment of interests with our clients is a critical component of our mission at Diamond Hill. As we have written previously,1 we align our interests with those of our clients in numerous ways, including:

  • Compensating portfolio managers based on investment results generated for clients over rolling five-year periods.
  • Having each portfolio manager invest alongside clients with a significant personal investment in the strategy they manage.
  • Offering a variable fee option to equity clients, linking management fees to investment results.
  • Giving each portfolio manager sole discretion in determining the capacity of the strategy they manage.

It is this last point that we will explore in this piece.

Why Capacity Matters

In the asset management industry, a common structural flaw exists, which was summarized by Warren Buffett in his 2016 Berkshire Hathaway annual letter to shareholders.

“There are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance… Third, most managers will nevertheless seek new money because of their personal equation — namely, the more funds they have under management, the more their fees.” 2

Below we have depicted these conflicting realities. Chart 1 demonstrates the concept that, under a fixed-fee arrangement, the more assets under management (AUM), the higher the revenue. Chart 2 illustrates that if a strategy is allowed to grow without consideration for the capacity of the strategy, the portfolio manager’s ability to generate excess returns for the client will eventually diminish.

Chart 1

Chart 1 Revenue and AUM

Chart 2

Chart 2 Excess Return and AUM

Herein lies the problem: many investment managers fail to properly address this issue, and the result can be detrimental to clients. If a portfolio manager is incentivized to grow assets under management, they may spend their time attracting new clients rather than delivering outstanding investment results for existing clients. In addition, this hypothetical investment manager may allow the strategy to grow to a point where the size of the strategy begins to inhibit their ability to generate excess returns.

At Diamond Hill, we seek to grow our strategies to the point where our revenue supports our ability to attract and retain the investment team necessary to maximize excess returns for our clients while simultaneously protecting the portfolio manager’s ability to add value.

The way we address the potential conflict of interest outlined above is by linking portfolio manager compensation to long-term (rolling five-year period) investment results, giving each portfolio manager sole discretion in determining the capacity for the strategy they manage, as well as decision rights on when a strategy will be soft closed. As such, the portfolio manager’s interests are aligned with our clients in two ways.

  1. Because incentive compensation is based on investment results, the portfolio manager is incentivized to close a strategy before it reaches a size where their ability to generate excess return is hindered.
  2. Through meaningful investment in their strategies, portfolio managers are incentivized to optimize investment results rather than grow assets under management because their personal investment, along with our clients’ investments, also benefit from excess return generation.

Capacity management is a critical component for acting in the best interests of clients. At Diamond Hill, we believe that the ability to add value for our clients is predicated on our willingness to look different from the benchmark (and to be right). However, in order to deliver a high-conviction, truly active portfolio we must first ensure a foundation of capacity discipline. Without capacity discipline, the ability of an active manager to outperform the benchmark for clients is hindered. At Diamond Hill, we are committed to prudent capacity management that puts our clients’ best interests first.

Determining Capacity Estimates

Capacity estimates are achieved with elements of both art and science. There is not one straightforward formula that determines the exact capacity for a strategy, but there are a number of factors that come into play, including:

  1. Our ability to take a meaningful position in companies across the full market cap range.
  2. Liquidity considerations for the strategy.
  3. Our goal to continue as a long-term partner with existing clients.

Utilizing the Full Opportunity Set

Why does the ability to generate excess return diminish as a strategy grows larger? If assets are allowed to grow without consideration for capacity, then there comes a point at which the manager is no longer able to take a meaningful position across the full market capitalization spectrum in their investable universe. As such, the manager is then forced to pass up alpha opportunities, invest in a greater number of positions, or put a greater amount of capital in companies with a larger market cap, which means that the portfolio will begin to look more like the benchmark it is trying to beat, inevitably making this proposition more difficult. Let’s take a look at an example using the large cap universe, approximated by companies within the Russell 1000 as of December 2019.

Number of Companies in the Russell 1000 Index by Market Capitalization

Number of Companies in the Russell 1000 Index by Market Capitalization

Source: FactSet

HYPOTHETICAL LARGE CAP STOCK EXAMPLE

Given the highly liquid nature of many mega cap stocks, investors often underestimate the importance of capacity for a strategy like large cap. However, the large cap universe encompasses a wide range of market capitalizations, and it is important to consider the potentially adverse impacts of unconstrained asset growth. In the example above, we consider a hypothetical manager with $50 billion in assets. To build a modest 1% position in a $5 billion market cap company, the manager would need to purchase 10% of shares outstanding. Even as the manager moves up the market cap spectrum, they would still need to acquire 5% of a $10 billion company just to establish a 1% position in their strategy. This would make it somewhat difficult for this hypothetical manager to establish a 1% position in nearly half of the companies in the Russell 1000.

All of this is even more important as you move down the market cap spectrum toward small cap. What if you wanted to purchase a higher-conviction position, say 2%? Let’s see what this would look like for a hypothetical investment manager lacking capacity discipline investing across the market capitalization spectrum.

HYPOTHETICAL 2% POSITION EXAMPLE

In each hypothetical example, a 2% position at the lower end of the market cap range would be impossible to establish without adverse market impacts. At Diamond Hill, this is a very important consideration of our capacity discipline, as we seek to put the most capital behind our highest-conviction ideas while still delivering a diversified portfolio for our clients. As such, we maintain relatively concentrated portfolios. For example, our Large Cap strategy holds 40 to 60 positions, with over 30% of assets in the top ten holdings. Preserving the ability to maintain a high-conviction portfolio while still utilizing the full market cap spectrum available to us is directly linked to our capacity discipline.

Liquidity Considerations

In determining the capacity for a strategy, we also consider the liquidity of the stocks we own and how long it would take to trade in and out of a stock without impacting the market for that position. Let’s revisit the hypothetical manager that allowed their large cap strategy to grow to $50 billion. How long it would take the manager to establish or exit a 1% position without having a significant market impact, meaning only trading 20% of the average trading volume per day?

ESTABLISHING A 1% POSITION FOR A MANAGER WITH $50B IN AUM (AS OF DECEMBER 2019)

* Used three-month average volume x 50-day average share price.
** Assuming 20% of average volume.

In the table above, we use actual information for three companies currently held in our Large Cap strategy. You can see that liquidity – as estimated by days to purchase a 1% position – is actually less for the two higher market cap positions versus the smallest market cap position. This shows that, in addition to market cap size, average trading volume must be considered when determining capacity. The example above demonstrates that if a strategy is allowed to grow too large, it can become onerous to trade in and out of positions without having an adverse market impact.

Long-Term Partnership

The final element of our capacity management philosophy is prioritizing and valuing our partnerships with existing clients. When we have soft closed strategies in the past, we have done so at a point where there is remaining capacity for us to continue our long-term partnerships with existing clients, allowing them to add additional capital to the strategy. In our experience, soft closing strategies has been a sufficiently successful tool in tempering inflows for the strategy such that we have not needed to elevate to a hard close.

We have a demonstrated track record of closing strategies to protect existing clients. Recent examples include:

  • Long-Short – soft closed June 2015
  • Small Cap – soft closed December 2015
  • Small-Mid – soft closed April 2016

While the Small-Mid strategy remains in a soft close status, Small Cap and Long-Short have recently re-opened to new investors. The following table shows the current capacity estimates for our most widely held equity strategies.

CAPACITY ESTIMATES

Conclusion

Capacity management is a critical component for acting in the best interests of clients. At Diamond Hill, we believe that the ability to add value for our clients is predicated on our willingness to look different from the benchmark (and to be right). However, in order to deliver a high-conviction, truly active portfolio we must first ensure a foundation of capacity discipline. Without capacity discipline, the ability of an active manager to outperform the benchmark for clients is hindered. At Diamond Hill, we are committed to prudent capacity management that puts our clients’ best interests first.

As of December 31, 2019, Diamond Hill owned shares of Axalta Coating Systems Ltd., BorgWarner, Inc., and Hanesbrands, Inc.

1 For more detail, read our 2011 investment letter “Active Management Fees and Alignment of Interests.”

2 Berkshire Hathaway 2016 Annual Shareholder Letter.

The Russell 1000 Index is an unmanaged market capitalization-weighted index comprised of the largest 1,000 companies by market capitalization in the Russell 3000 Index, which is comprised of the 3,000 largest U.S. companies by total market capitalization. This index does not incur fees and expenses (which would lower the return) and is not available for direct investment.

The views expressed are those of Diamond Hill as of January 2020 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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