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Is there a capacity constraint facing 130/30 strategies?


Date: Friday, March 30, 2007
Author: All About Alpha

A few years ago, the hedge fund industry was all abuzz about the “capacity constraint” facing many hedge fund strategies. However, while certain strategies (e.g. merger arbitrage) exploited a limited set of opportunities, most funds (particularly those of the ubiquitous long/short persuasion) seemed to keep on trucking. Due to continued industry growth and some academic studies suggesting these concerns were overstated, “capacity constraint” hasn’t been rolling off the tongues of those on the hedge fund conference circuit and in the hedge fund media as easily recently.

So it’s curious to see a resurgence of this concern coming not from the usual suspects (hedge fund managers threatening to close to new investors), but from outside the industry: in the 130/30 arena. As early as last fall, Goldman Sachs was getting the alarm bells out of the attic and warmed them up. In a report on 130/30, The Firm said:

“In many ways, wondering about the capacity of 130/30 strategies might seem unnecessary, or at least premature. These strategies are still too new to have gathered significant assets: several firms only recently launched their versions of 130/30, and many others are still in the process of doing so. And yet, given the tremendous potential benefits of relaxing the noshorting constraint, 130/30 strategies are sure to attract substantial amounts of capital, and when they do, capacity could become an issue for many managers.”

“Concerns about capacity arise because growth in assets, if left unchecked, can have an adverse impact on a strategy’s performance. Growth can hurt performance two ways: directly, by increasing costs (and thereby reducing a portfolio’s realized returns net of costs), and indirectly, by altering the optimal set of active weights (and thereby reducing a portfolio’s expected returns before costs).”

Yikes! Higher trading costs and a sub-optimal portfolio? Sounds bad. But the report contains the following chart that shows the growth in both “lendable assets” and “on loan” assets. Contrary to Goldman’s concerns, it seems there is no shortage of stock to lend (note the difference scales).

To be sure, hard to borrow stocks would certainly become more expensive if everyone jumps into the 130/30 game in the short run. But in the long-run, that should pull more long investors into lending their stocks.

What about hard-to-borrow small caps with small floats and/or stubborn majority owners who refuse to authorize their brokerage to lend out their stock? Sure, this a constraint. But it’s a constraint no different from that faced by long-only small cap managers. After all, they face stock shortages every day and what happens? Prices go up until buyers lose interest.

The report also points to the fact that most 130/30 managers concurrently manage other more passive long-only funds (e.g. enhanced index funds). As a result, their active bets (”best ideas”) need to be spread around. With their emphasis on active management, 130/30 funds will need to absorb a disproportionate amount of these limited ideas. But those passive funds are also a lot larger. If they haven’t hit a capacity wall, then it’s entirely likely that 130/30 funds won’t either.

In an acknowledgement that 130/30 capacity concerns are a bit of a stretch, Goldman slips in an interesting footnote on the topic:

“Of course, growth can also have a positive impact on a strategy’s performance. Growth can create scale that reduces average costs (e.g., by giving a portfolio manager more clout to negotiate better terms from a prime broker). Growth can also generate resources that improve returns (e.g., by funding research). Hence, the net impact of growth on performance is ambiguous, and is likely to vary across strategies and managers.”

While the jury is apparently out at Goldman Sachs, we at AllAboutAlpha will go out on a limb here and suggest that 130/30 is a long way away from hitting a capacity wall. The alarm bells can go back in the attic for a while.