CAPACITY MANAGEMENT: A KEY RISK MEASURE

Transcription

1 MFS White Capability Paper Series Focus Month May 2016* 2012 Authors CAPACITY MANAGEMENT: A KEY RISK MEASURE Michael T. Cantara, CFA Head of Global Client Group Joseph C. Flaherty Jr. Chief Investment Risk Officer IN BRIEF Capacity management is an integral component of the investment process. Preserving alpha-generating capability for clients is an overarching guiding principle in the review of capacity at MFS. Capacity is considered under the rubric of risk and evaluated in a systematic semiannual process along with other portfolio risks. The firm s approach to capacity management includes quantitative analysis and qualitative assessments as well as additional non-portfolio considerations. The steps taken to manage the growth of assets in MFS Global Equity strategy since 2006 present a clear case study on capacity management decisions. John E. Stocks, CFA Quantitative Research Analyst Ravi B. Venkataraman, CFA Global Head of Consultant Relations Success in asset management leads to a well-known conundrum: how to best manage increases in assets under management (AUM) while continuing to generate value-added alpha for clients. A growth in AUM may make it more difficult to implement a strategy by imposing certain costs and impediments, such as liquidity constraints, potentially higher transaction costs and client-servicing requirements, as well as the need to ensure adherence to the strategy. Business diversification across multiple strategies and investment teams is another important consideration when evaluating the capacity of individual investment strategies. This is key to ensuring a sustainable business model, which in turn impacts individual product performance. Capacity can be managed in various ways, including with the implementation of product closures, which are designed to protect the interests of existing clients by limiting further inflows. In this case, we are referring to both clients in the strategy of interest as well as clients more broadly in strategies that may overlap with the * A version of this paper was first published in May 2014.

2 product in question. Preserving alpha-generating capability for existing clients is paramount in our view, and is at the heart of capacity management. It is in this context that capacity management is viewed as an integral component of risk management at MFS. While there is general agreement among asset managers and their clients that products need to be closed for capacity reasons, there is little consensus on how capacity should be measured. Various academic and industry studies have offered a number of quantitative tools to help determine product capacity; however, these approaches are sensitive to the underlying assumptions made and none is definitive. Not only is capacity hard to measure, it is also a function of current market conditions and the characteristics of a given strategy. Certain asset classes are inherently more capacity constrained than others. Portfolios invested in large-cap US equities have significantly more capacity than portfolios invested in either small-cap or emerging market equities. Highly concentrated portfolios (e.g., 20-stock portfolios) generally have less capacity than more diversified portfolios, depending on the liquidity of stocks included in the portfolio. Portfolios with high turnover require greater market liquidity and therefore have less capacity than portfolios with lower turnover that can patiently trade over longer holding periods. One should bear in mind that all these parameters interact with one another and market conditions change over time, so portfolio characteristics must be fully examined before applying generalizations about capacity. In this paper, we outline MFS approach to managing capacity in equity portfolios in some detail to illustrate the firm s philosophy and considered methodology. We also provide information on the product restriction decisions made with regards to the Global Equity strategy as a case study. The way capacity is considered from a fixed-income portfolio perspective is addressed briefly on page 8. MFS approach to capacity management MFS employs a combination of quantitative analysis and qualitative assessments to help measure and manage capacity, and also takes other non-portfolio considerations into account such as idea generation, business diversification and portfolio manager non-investment responsibilities (see Exhibit 1). Discussions regarding capacity focused on the individual strategy level take place formally every six months as part of the MFS risk review process. In addition, capacity is examined at the firm level on a periodic basis. Product risk profiles and investment style are monitored on an ongoing basis to ascertain whether a growing asset base is leading to shifts in a product s risk profile or style. Trading patterns and transaction costs are also monitored to determine whether rising assets are making a strategy more difficult and expensive to implement. Exhibit 1: MFS approach to capacity management Quantitative model Non-portfolio considerations CAPACITY REVIEW Qualitative assessment Guiding principles The firm s approach to capacity management is guided by these important principles: Protecting clients interests Capacity management is an integral part of MFS client-centered strategy. We are committed to continually monitoring and prudently managing product capacity consistent with the firm s commitment to maintaining product integrity and adding sustainable value for our clients. At the core of the firm s strategy is a commitment to ensuring that existing clients are not adversely impacted by the rising costs and declining performance that can result from capacity constraints. Aligning compensation Portfolio managers at MFS are not paid based on AUM but rather on their contribution to the firm, viewed through the prism of long-term investment performance and collaboration with colleagues. This ensures that the portfolio manager incentive structure is aligned with clients interests and the long-term performance of portfolios. This alignment of interests is an important principle in our view as it ensures that portfolio managers are not incentivized to take on more assets than may be prudent, but rather the reverse. 2

3 Considering capacity management a risk measure At MFS, capacity management is evaluated under the rubric of risk and, as such, is a component of the semiannual risk review process, which involves an in-depth examination of portfolio risks with senior management. Capacity management is reviewed in this context along with other risk measures. The semiannual risk review ensures there is a systematic process to monitor and measure capacity for every equity strategy at MFS. Preserving alpha-generating capability for existing clients is paramount in our view, and is at the heart of capacity management. It is in this context that capacity management is viewed as an integral component of risk management at MFS. Quantitative capacity model The capacity management process begins with a quantitative framework, in which product capacity forecasts are generated based on factors such as share ownership and trading volume, and considering the holdings overlap across multiple MFS products. Sensitivity analysis is performed around all of the assumptions inherent in the quantitative analysis to generate a multidimensional grid of capacity estimates. The basis of the capacity model is to establish the constraints on replicating an existing portfolio at increasing levels of AUM, i.e., determining the aggregate assets that can be managed in the strategy as it is positioned at the time. In the model, we do not attempt to adjust for market appreciation, make portfolio positioning assumptions or account for how managers might react in the face of capacity constraints. Ownership limits are initially set for the overall organization at the security and issuer level. As a multistrategy firm with cross-ownership among strategies, exposure needs to be monitored across the complex. This leads to the need for certain product share assumptions. The product share figures are then applied to incremental available securities or the modeled growth in assets. The two primary factors we use to set ownership limits at the security level are: percentage ownership of average days trading volume (ADV) percentage ownership of the shares outstanding of a company Capacity model detailed The capacity model includes the following steps: 1. Determine security/issuer level ownership constraints for the entire firm for all securities held within the portfolio being measured Ownership constraints are set by the percentage of shares outstanding and the percentage of average days trading volume (ADV). Percentage of shares outstanding = MFS aggregate shares/total shares outstanding The calculation of the percentage of shares outstanding takes place at the equity issuer level and accounts for multiple listings, share classes, ADRs/GDRs, etc. We model this limit at a 10% threshold for all securities, although we may own up to approximately 15% in some stocks. Percentage of ADV = MFS aggregate shares/90-day average trading volume We use three base scenarios to assess the liquidity of ownership: 5 days, 10 days and 15 days of ADV. The number of days trading in this calculation refers to the total shares owned over the period at 100% of volume. 1,2 2. Calculate the number of incremental shares available to MFS For each security in the portfolio, we calculate the difference between the aggregate shares currently owned by MFS and the total shares set at each ownership constraint level defined above. We call this the incremental shares available for purchase. 1 This should not be confused with the number of days we expect it to take to liquidate a position. In other words, when we set the limit at 10 days volume, it does not mean we are setting a limit of 10 days to liquidate a position. In order to measure liquidity on the basis of time, we would need to add an estimate of a given participation rate. Typical participation rates on larger orders range from 10% to 25% of ADV but may be significantly larger or smaller depending on the market conditions for a security on a given day. 2 In addition, we make numerous adjustments to get accurate estimates of the trading volumes. This includes, for example, aggregating the trading volumes across multiple listings such as ADRs, GDRs, dual-listed Canadian stocks, etc., in order to capture the liquidity that is actually available to our traders. We also source volume for certain securities from nonstandard sources. For example, when Russian and Thai securities report no volume for a particular share class, we have a process for identifying these holdings and sourcing the correct volume from Bloomberg. 3

4 For example, if MFS currently owns 100,000 shares of ABC company and the minimum of 10% shares outstanding or 10 days trading volume is 250,000 shares, as a firm we may now purchase 150,000 more shares before hitting our limit. 3. Assign a range of product share assumptions and calculate shares available to purchase for this single strategy We will assign a range of product share assumptions, which are generally related to the current average product share. These are sometimes adjusted to take account of perceived changes in the product opportunity going forward. In each case, we determine the number of shares available for the particular strategy to own given the overlap and internal allocation with other strategies. Following on from the example above, if the firm can buy 150,000 more shares of ABC company, in a 25% product share scenario, we would calculate that this strategy could purchase 37,500 incremental shares in ABC company s stock. 4. Determine what percentage of the portfolio to replicate without breaching any of these ownership limits We can approach this in a couple of different ways. One way is to ask ourselves how much of a portfolio we are willing to own in securities where MFS has a significant ownership in terms of average trading volume or shares outstanding. The other way is to say that we want to be able to immediately replicate a certain percentage of the portfolio so that when future assets come in the door, the portfolio managers have some implementation flexibility, but not to the point of deviating from the strategy. We have been using an 80% immediate replication rate, which means that we allow for 20% substitution. In practice, MFS equity portfolios have been replicated at much higher rates and typically fully. Further adjustments are made to the model depending on whether the assets are held in commingled or separate accounts. Commingled accounts, which benefit from the base of existing assets, will have greater capacity for incremental flows than a full funding of a separate account under this approach. 5. Run the analysis for the various scenarios of product share and percentage of ADV The model then runs an iterative process to find the AUM, when 20% of the positions by weight are in securities which have breached the assigned incremental shares. The output is a matrix of AUM capacity estimates for each scenario. An example of the capacity model output is provided in Exhibit 2 below. In this case, a portfolio with a current AUM of $10 billion was considered. Assuming a 30% product share for this portfolio, the capacity model suggests that assets could range from $18.8 billion under a 5-day trading volume constraint to $55 billion if the trading volume constraint is set to 15 days. For a given number of days trading volume, increasing the product share percentage also increases the capacity estimates, though to a lesser degree than when one varies days trading volume. This highlights the point that capacity estimates are always a range and never a single number. The table and chart below illustrates the way in which the model produces various capacity ranges based on the various inputs and constraints imposed in the model. Exhibit 2: Example of capacity model output matrix for commingled portfolio Assumptions: Replication of portfolio: 80% Max: MFS ownership % shares outstanding: 10% Strategy current AUM: $10 billion Product share Days Trading Volume (ADV) 5 days 10 days 15 days n 20% n 30% n 40% AUM Source: MFS. 40% 30% Product share 20% 5 days 10 days ADV 15 days 4

5 Quantitative example The sensitivity of the quantitative model outlined to changes in the input variable assumptions can be illustrated using the following example of a large-cap US equity portfolio (Portfolio A). The first test involves replicating Portfolio A at increasing asset levels, then examining trading volume and percent of outstanding shares owned for each position in the portfolio. In this case, we limit aggregate MFS ownership of an individual stock to 10 days trading volume and 10% of the company s outstanding shares, and assume that Portfolio A s product share percentage is 30% (see Exhibit 3). The chart shows the proportion of Portfolio A that can be replicated as assets grow under the constraints stated. In this case, the 80% replication level is reached when assets are approximately $35 billion. In the second test, Exhibit 4, we assume that Portfolio A is fixed at assets of $35 billion, product share allocated to the portfolio is fixed at 30% and ownership of outstanding shares is limited to 10%, while we reduce the number of days trading volume we are willing to hold. In the graph below, we show that the percent of Portfolio A that can be replicated decreases as the days trading volume constraint is tightened. In the third test, Exhibit 5, we keep the size of Portfolio A fixed at $35 billion, the days trading volume constraint fixed at 10 days and the ownership of outstanding shares limited to 10%, while varying the product share constraint. In this example, only 85% of the portfolio can be replicated even if Portfolio A absorbs all available liquidity, i.e., if it assumes 100% of the product share. Qualitative review The capacity analysis described can potentially lead to a wide range of capacity estimates largely because capacity models tend to be driven by the assumptions employed (i.e., number of days to establish or exit a typical position, strategy overlap, etc.). In addition, to arrive at more accurate estimates of trading volume we make adjustments to standard reported volumes by, for example, taking account of multiple listings, the fragmentation of the European trading market and volumes traded on alternative lesstransparent trading platforms. Exhibit 3: Replication positions at varying AUM for Portfolio A Replication positions 100% 90% 80% 70% 60% Source: MFS. Assumptions: Ownership % = 10% Trading volume = 10 days Product share = 30% Future assets ($ billions) Exhibit 4: Replication positions at varying trading volume constraints for Portfolio A Replication positions 100% 80% 60% 40% 20% Source: MFS. Assumptions: Ownership % = 10% Product share = 30% Future assets = $35 billion Days trading volume Exhibit 5: Replication positions at varying product share constraints for Portfolio A Replication positions 100% 80% 60% 40% 100 Source: MFS. Assumptions: Ownership % = 10% Trading volume = 10 days Future assets = $35 billion Product share

6 For these reasons, qualitative input from portfolio managers and the trading desk regarding the ease or difficulty associated with implementing the strategy and maintaining the investment style is extremely important. The capacity model is discussed as part of the semiannual risk review process at MFS, and it is in this context that a qualitative review of the matrix of capacity estimates takes place. The broader risk measures prepared for the review contain additional information that helps put the portfolio in perspective in terms of the risk profile and portfolio characteristics, as well as trading costs and performance. Trading costs, turnover, style consistency and overlap are some of the elements related to capacity that are examined in detail in the risk review alongside the capacity model output. Trading costs Trends in trading costs can be an important source of information with regard to how the AUM base may be impacting transaction costs and potentially reducing the manager s ability to add alpha. However, it should be noted that trading costs are also a function of the market environment, tend to vacillate for a variety of reasons and may not be indicative of capacity constraints. In general, the centralized risk management platform employed at MFS provides a broad, effective lens with which to evaluate trading costs and other risk measures. Turnover The longer-term investment time horizon at MFS means that turnover for the firm s strategies is generally on the low end of the spectrum. This is as true for the strategies with low AUM as it is for those with higher AUM. Turnover is also viewed in concert with liquidity risk, in that lower turnover strategies can take on more liquidity risk. For example, even at a higher cost per trade, incrementally higher trading costs may not have a significant impact on a portfolio with turnover of 15% compared with a portfolio with turnover of 100%. Style consistency This encompasses a number of elements like name count, active share, average market capitalization relative to an index, growth/value style drift and any other changes in portfolio investment characteristics. In general, any significant changes that cannot be rationally explained by market dynamics would come under the spotlight as part of the risk review. It should be noted, too, that style consistency is examined as a key risk measure on an ongoing basis. Overlap in strategies The capacity considerations related to strategy overlap across the firm is also part of the risk review process. The product share assumptions used in the capacity model may be revisited in this context. Capacity estimates are always a range and never a single number. Non-portfolio considerations The capacity review comprises the quantitative and qualitative portfolio considerations outlined above as well as additional non-portfolio factors such as those listed below. Idea generation At MFS, the global research platform forms the backbone of the firm s investment idea generation. Analyst opinions, expressed in the form of a ratings system, continue to be the dominant source of new ideas for all our client portfolios, regardless of asset class or style. The platform has been strengthened and expanded in the past several years by additional resources and the opening of new investment offices in Hong Kong, São Paulo, Sydney and Toronto in order to exploit the growing universe of investment opportunities globally. We continue to be cognizant of investment idea generation as we evaluate capacity decisions, given that expanded research coverage allows for greater firmwide capacity. Business diversification Diversifying assets across multiple strategies is another important consideration in evaluating the capacity of individual investment strategies. MFS believes that diversification translates into long-term stability for the firm, in part by also allowing for broader investment talent contributions, and for these reasons actively manages the business risk associated with product concentration. Portfolio manager time constraints Portfolio manager non-investment responsibilities are also a consideration when capacity is under review. While we seek to maximize value added for our clients by using institutional portfolio managers and investment product specialists to support the client base so that portfolio managers are able to focus on managing investments, new business often brings with it additional portfolio manager marketing and service requirements. 6

7 GLOBAL EQUITY CASE STUDY In April 2006, the decision was made to soft close the Global Equity strategy to new separate accounts. Pooled vehicles for new and existing institutional investors remained open until December 2011, when institutional pooled funds were closed to new accounts. In March 2013, further restrictions for separate account clients were announced, with contributions from then-current separate account clients only being accepted until September The vehicles designed for individual investors have remained open. Exhibit 6: Global equity capacity management decisions Apr 2006 Soft close No new separate accounts Dec 2011 Closed institutional pooled funds to new accounts Oct 2013 Contributions from current separate account clients no longer accepted The rationale for closing Global Equity was that it would slow the growth of assets for the following reasons: Protect the interests of existing and future clients by preserving investment flexibility for portfolio managers such that they are able to potentially deliver performance in line with client expectations Preserve capacity for other existing strategies as well as the prudent launch of new investment strategies driven by client demand Minimize the non-investment responsibilities of the portfolio managers by limiting large mandates that usually require significant marketing and service requirements to allow the existing client portfolios to receive the requisite focus Portfolio characteristics The portfolio managers have been able to continue to pursue active alpha-generating investment opportunities in line with the investment philosophy and process for the strategy. Portfolio characteristics have remained relatively consistent over time. 7

8 Fixed-income capacity management As we mentioned in the introduction, this paper is largely focused on outlining our approach to managing capacity in equity portfolios. Our capacity methodology in the case of fixed income is similar in certain respects to equities; however, there are also some key differences. The overall architecture of the capacity review is comparable in that they both comprise three key elements: quantitative model, qualitative assessment and non-portfolio considerations. The nature of the securities and the markets means that the fixed-income quantitative model differs in the following regards: Trading volume is not considered in the fixed-income model. Replication constraints are placed at both the bond issue and the issuer level. Only non-government issues are considered in the replication process. Product closure decisions Based on the various factors described above, product closures are implemented at appropriate asset levels to protect the interests of our clients. The interests of existing and future clients are protected by preserving investment flexibility for our portfolio managers. The MFS goal is to put each portfolio manager in the best potential position to generate superior risk-adjusted performance for our clients. The firm has tended to adopt a staged approach to managing capacity in the past, with soft close decisions preceding hard closure of the strategy, in part to minimize business disruptions for clients invested in the strategy. This is illustrated in the timeline provided for the capacity management decisions made with regard to the Global Equity strategy (see page 7: Global Equity Case Study). When circumstances change, we have also made the decision to reopen strategies or roll back the soft close. A differentiated approach is often adopted for the retail versus institutional markets to account for the fact that it is much easier to accommodate inflows of smaller amounts of retail assets than it is to absorb larger pools of funds in institutional separate accounts. Also, it is worth noting that a proportion of institutional account redemptions take place on a regular basis for reasons outside the control of the investment manager concerned. In this context, the inflow of retail assets can be seen as replacing some of these institutional outflows. MFS has imposed restrictions on strategies other than Global Equity in keeping with the approach outlined in this paper. Currently, the list of strategies subject to a restriction of some kind includes European Research, European Smaller Companies, European Value, Global Concentrated, Global Value, International Small Cap, International Value and US Large Cap Value, in addition to Global Equity. This list is an indication of the commitment MFS has made to a rigorous capacity risk review process and, in doing so, protecting clients interests. Conclusion MFS employs both quantitative analysis and qualitative assessments to help measure and manage capacity. Given how important capacity management is to the overall investment process, we consider capacity under the rubric of risk and review capacity within the context of the semiannual risk review process. Idea generation, business diversification and portfolio manager non-investment responsibilities are additional considerations taken into account in capacity decisions. The firm has taken steps to close a number of products in line with the capacity management approach outlined in this paper. This includes the soft close imposed on Global Equity in 2006, which has been followed by additional restrictions on asset inflows into the strategy. In general, we are committed to managing capacity to preserve alpha-generating capability for clients. We believe that we can build trust and credibility with clients by working in their interests, and simultaneously create a business model that is sustainable in the long term. 8

9 The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. ( MFSI ) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited ( MIL UK ), a private limited company registered in England and Wales with the company number , and authorized and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered offi ce at One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. This material shall not be circulated or distributed to any person other than to professional investors (as permitted by local regulations) and should not be relied upon or distributed to persons where such reliance or distribution would be contrary to local regulation. Issued in Hong Kong by MFS International (Hong Kong) Limited ( MIL HK ), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the SFC ). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to professional investors as defi ned in the Securities and Futures Ordinance ( SFO ). Issued in Singapore by MFS International Singapore Pte. Ltd., a private limited company registered in Singapore with the company number M, and further licensed and regulated by the Monetary Authority of Singapore. Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian fi nancial services license under the Corporations Act 2001 in respect of the fi nancial services they provide. In Australia and New Zealand: MFSI is regulated by the U.S. Securities and Exchange Commission under U.S. laws, and MIL UK is regulated by the U.K. Financial Conduct Authority under U.K. laws, which differ from Australian and New Zealand laws. MFSE-CAPAC-WP-5/