Thread: Capacity

Capacity is a structural issue that is influenced by many variables. When
industry professionals talk about “capacity,” they refer primarily to the maximum
assets that a hedge fund can manage before performance starts to deteriorate.
On a secondary basis, they may also be referring to the maximum
number of people that a hedge fund may want to employ and the size of the
infrastructure that they want to manage. Not all boutique hedge fund managers
want their businesses to grow into substantial asset management companies
with the operational, political, and bureaucratic characteristics typical
in such companies.
It is well known that a limited number of managers demonstrate the ability
to outperform over time. For many managers, performance often
degrades once assets grow beyond a certain level. The reason for this is simple:
slippage (sometimes called friction). Slippage is defined as the degree to
which market prices are moved through the process of entering or exiting a
position. The larger the position, the greater the effect of slippage


Concern regarding assets under management varies from investment
strategy to investment strategy. Funds focusing on investing in the currency
markets should be able to manage much more money than funds focusing
on exotic fixed-income arbitrage opportunities. Funds focusing on largecapitalization
stocks should be able to manage more than those specializing
in the micro- or small-capitalization arena. The overall health of the global
economy, the liquidity in the markets, the types of market participants, and
the regulatory environment all contribute to the “capacity factor.”

Much noise has been made about the need for greater transparency since
the bailout of Long Term Capital Management in the third quarter of 1998.
Greater transparency is commonly associated with providing greater investor
protection from both a performance and a fiduciary perspective. This is not
always the case. Transparency is a double-edged sword with the potential
to be misunderstood and misused.
Certain levels of transparency are essential for effective due diligence.
Investors and asset allocators must have some ability to look through to the
underlying portfolio to understand whether the manager is adhering to stated
investment parameters and whether the investment methodology is consistent
with stated objectives. This is particularly true for managers investing
in unlisted securities and derivative instruments.
There is a curious dichotomy in the mindset of investors in alternative
investments. Investors in private equity funds view lack of transparency and
liquidity as par for the course and, often, as a benefit. However, lack of transparency
and liquidity in a hedge fund can be regarded as a disadvantage.
Much of the recent clamor for transparency has focused on managers
supplying full portfolio information to investors on a real-time basis. In this
instance, transparency can have the ability to do more harm than good. The
reasons are very straightforward:

If the portfolio information is leaked to the marketplace, it can be used
by other market participants against the manager and thereby against
the best interests of the investors.

It can cause the management of companies, in whose stocks a manager
may be short, to cut off the flow of information. Again, this works
against the best interests of investors.
Furthermore, we have seen no empirical evidence to show that the use
of the ubiquitous value-at-risk (VAR) models (which are based on the
mathematical formulae developed by some of the professionals who

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38 HEDGE FUNDS
formed so badly in 1998) protects investors from major market setbacks.
The reasons are threefold: (1) correlations are increasingly dynamic; (2) in
a crisis, all correlations go to one; and (3) the Reverend Thomas Bayes1
notwithstanding, modeling the unpredictability of human behavior is not yet
a perfect science.
Real-time transparency is only valuable in two circumstances: (1) if you
have real-time liquidity—that is, you can get in or out of the fund whenever
you choose—or (2) if you can proactively manage the risk profile of the
investment, such as overlay trading to act as a hedge. Few investors have
either of these advantages. Hedge fund liquidity is usually monthly or quarterly,
and few investors are in a position to second-guess the managers’
investment decisions.
By definition, more transparency means more information. Fifteen
years ago there were discreet advantages to having information ahead of
the crowd because you could act on the information before its impact was
generally understood. Today, by the time you get the information, it is old
and everyone else has it, too. Therefore, you have no time to react before
the herd.
The inherent return of hedge funds comes from providing investors with
the premia that the markets make available to investment professionals who
can take positions in securities when others can’t, won’t, or need to be on
the opposite side. Full portfolio transparency may reduce the manager’s ability
to pick the premia off the table and thereby reduce the inherent return.