When Is a Small-Cap Strategy Too Big?
For small-cap equity managers, liquidity is always a challenge. But how can you really know when a strategy is too big to move in and out of positions efficiently?
Asset managers of all types frequently grapple with capacity issues. These questions are even more acute for a small-cap growth manager. Since small-cap stocks are seldom widely held and are thinly traded, it can be tricky to trade quickly when you need to. And growth managers tend to be bigger “consumers” of liquidity, because they’re often competing with others to buy companies that are in favor by virtue of their strong fundamental momentum. In contrast, value managers can be a source of liquidity for the market because they typically buy stocks that are out of favor, which others are willing to sell.
There are some benefits to being big. For example, firms that manage larger strategies have more resources to spend on research, which can be relatively expensive for smaller stocks. Bigger strategies are also more capable of attracting and retaining top talent and they generally enjoy better access to management.
Yet respecting capacity constraints can determine whether managers are capable of delivering on their promises. The guiding principle should be to make sure that the strategy isn’t too large to generate its target premium. While the technicalities of capacity are complex, there are a few key concepts that can help investors figure out whether a strategy is too big for its own good:
- Days of volume owned—how many days will it take your manager to exit or enter a typical position, based on the trading volume of the securities held by the portfolio?
- Transaction costs—does your manager have a good grip on how much it will cost—not just transaction fees but more importantly market impact costs—to accumulate or dispose of larger positions? The bigger the strategy, the more it will cost to move in and out of positions.
- Turnover—how aggressive is your manager’s turnover? Higher turnover managers need higher volume than lower turnover managers to execute their strategy effectively at a similar size.
- Name count—how many individual stocks will be held in the portfolio? As capacity grows, some managers increase the name count, but this can make it harder to beat the benchmark. Ask your manager to explain what the optimal number of stocks is for delivering their targeted premium.
- Ownership limits—investors in smaller cap stocks are more sensitive to regulatory constraints on ownership limits, since by definition, these stocks have fewer shares outstanding.
Managers should be willing to close a successful strategy—and forfeit future fees—if capacity constraints are likely to undermine portfolio performance. This is never an easy decision: closing a successful service to new strategies is often unpopular internally, as well as with prospective clients seeking to get in on the action.
Investors should be aware of the issues, especially when seeking to enter a service that has a strong track record combined with rapid growth. While the answers to these questions are more art than science, portfolio managers who have a good grasp of capacity constraints should be able to explain clearly their approach to all these matters.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Bruce Aronow is Senior Portfolio Manager and Team Leader—US Small/SMID Cap Growth at AllianceBernstein.