Trading Strategy Capacity

Trading strategy capacity refers to the maximum amount of capital that a particular trading strategy can effectively manage before its performance starts to deteriorate.

Each trading strategy has a finite capacity determined by various factors, such as the liquidity of the traded instruments, the breadth of the investment universe, and the frequency of trading signals.

It’s the analogous concept to the idea of “market size” in business and private forms of investing.

Exceeding this capacity can lead to adverse consequences, as the strategy may struggle to execute trades efficiently or may face increased market impact and slippage.

Capacity may also decrease due to competition.

Key Takeaways – Trading Strategy Capacity

• Both large institutions and smaller traders need to be aware of trading strategy capacity limitations.
• For large institutions managing significant amounts of capital, exceeding the capacity of their strategies can lead to substantial performance degradation.
• Smaller traders, while operating at a different scale, can also experience similar issues if they attempt to deploy excessive capital relative to the capacity of their chosen strategies.
• Small traders who lack a trading edge may simply pursue beta (market-following) strategies or pursue less-crowded opportunities, such as private markets and process-driven opportunities.
• Strategies for Managing Capacity:
  • Closing Strategies to New Investors
  • Launching New Funds
  • Fee Structures
  • Kicking Out Existing Investors

Why Strategy Capacity Matters

Understanding and respecting trading strategy capacity is important for both large institutions and individual traders.

When a trading strategy operates within its capacity limits, it can perform optimally, as the trades can be executed with minimal market impact and slippage.

Nonetheless, when the strategy’s capacity is exceeded, several issues can come up:

Market Impact

As the strategy’s trading volume increases beyond the capacity limits, the buy and sell orders can move the market.

This can cause prices to move against the desired direction.

This market impact can erode potential profits and increase the costs of trading.

Transaction costs in markets tend to increase in a non-linear way as your AUM goes up because you go from not just mostly the bid-ask spread as a transaction cost but market depth starts thinning out.

Liquidity Constraints

Certain trading strategies may rely on the availability of sufficient liquidity in the markets they trade.

When the strategy’s capital exceeds the available liquidity, it becomes increasingly difficult to execute trades efficiently.

This leads to wider bid-ask spreads, higher transaction costs, and potential slippage (execution prices deviating from desired prices).

Increased Competition

As more capital flows into a particular trading strategy, the opportunities exploited by that strategy may become more crowded.

These days, it’s not uncommon for competitors to reverse-engineer alpha (market-beating) strategies.

This can lead to diminished returns as the edges are arbitraged away by multiple market participants.

Risk Management Challenges

Managing risk effectively becomes more challenging as the capital deployed by a strategy grows.

Position sizing, options, stop-loss levels, and other risk management techniques may become less effective or harder to implement consistently at larger scales.

Factors Affecting Strategy Capacity

Market Liquidity

The liquidity of the assets traded by a strategy is an important factor in determining its capacity.

Strategies that operate in highly liquid markets, such as large-cap equities or major currency pairs, typically have higher capacity thresholds.

(And likewise, highly liquid markets tend to have the most competition accordingly.)

Conversely, strategies that trade in less liquid markets, like small-cap stocks or thinly traded derivatives, have lower capacity limits due to the potential for significant market impact.

When a strategy’s trading volume exceeds the available liquidity in the market, it becomes more challenging to execute trades without adversely affecting prices.

This can lead to increased slippage, wider bid-ask spreads, and diminished returns.

Trading Style

The trading style used by a strategy also work in determining its capacity.

High-frequency trading (HFT) strategies typically have lower capacity limits compared to longer-term strategies because they involve rapid entry and exit of positions.

This is because HFT strategies rely on exploiting fleeting market inefficiencies or arbitrage opportunities, which can be quickly exhausted as more capital is deployed.

On the other hand, longer-term strategies, such as those based on fundamental analysis or trend following, may have higher capacity limits.

These strategies typically hold positions for extended periods and allows for more gradual and efficient execution of trades.

Transaction Costs

Transaction costs, including commissions, bid-ask spreads, and market impact, can erode the returns of a trading strategy as trade sizes increase.

Even seemingly small costs can compound and become substantial when multiplied by the high trading volumes associated with large-scale strategies.

Strategies that involve frequent trading or operate in less liquid markets are susceptible to the effects of transaction costs.

As the strategy’s capacity is exceeded, the increased trading volumes can lead to wider bid-ask spreads and greater market impact, and worsen the impact of transaction costs on performance.

High transaction costs can effectively limit the capacity of a strategy, as the potential returns may be entirely consumed by the costs of trading.

This can render the strategy unprofitable – or non-value-additive relative to a benchmark – beyond a certain capital threshold.

Capacity Challenges for Hedge Funds and Institutional Investors

The Pressure to Grow

Hedge funds and institutional investors face constant pressure to grow their assets under management (AUM).

This pressure can stem from investors seeking larger allocations, the need to generate higher fees, or the desire to achieve economies of scale.

Nevertheless, this growth imperative often conflicts with the limitations imposed by trading strategy capacity.

As a fund’s AUM increases, it may become more difficult to maintain the same level of performance.

Strategies that once generated attractive returns may struggle to replicate those results when applied to larger capital pools.

This can lead to a potential decline in returns or increased risk-taking.

Funds have to balance the pursuit of growth with the capacity constraints of their trading strategies, as exceeding capacity can lead to diminished performance and potentially jeopardize investor confidence.

Alternatively, they’ll have to tap into second- and third-tier ideas with lower risk/reward.

Avoiding “Style Drift”

When faced with the need to accommodate more capital, funds may be tempted to drift away from their core trading strategies and venture into new markets or asset classes.

This “style drift” can occur when a fund’s existing strategies reach their capacity limits, prompting the search for new opportunities to deploy additional capital.

Style drift can be a double-edged sword.

While it may temporarily alleviate capacity constraints, it also introduces new risks and challenges.

Trading in unfamiliar markets or employing strategies outside the fund’s area of expertise can lead to suboptimal performance.

Clients also wouldn’t be happy if they believe their money is going toward a certain market strategy with certain risk parameters, but is actually doing something they don’t expect.

So, successful funds resist the temptation of style drift and stick to their proven strategies and investment/trading philosophies.

Maintaining a focused and consistent strategy is often more favorable than chasing new opportunities that may dilute the fund’s core competencies.

If they do drift, they’ll build up the requisite expertise first through new research, new hires, and/or new technology.

Finding Niche Markets

Some hedge funds and institutional investors attempt to circumvent capacity challenges by focusing on niche or less crowded markets.

These markets may offer higher capacity limits due to their relative illiquidity or the fewer number of market participants.

For example, a fund may specialize in trading less liquid asset classes, such as distressed debt, convertible bonds, or esoteric derivatives.

These markets may have lower overall liquidity, but they also tend to have fewer competitors, which can allow for higher capacity thresholds before market impact becomes a significant issue.

Alternatively, funds may seek opportunities in emerging or frontier markets, where there’s less competition and potentially more inefficiencies to exploit.

These markets may provide greater capacity for certain trading strategies, at least until they become more crowded and efficient.

By operating in niche markets, funds can potentially increase their capacity limits and continue to generate attractive returns without being constrained by the limitations of more crowded or liquid markets.

Capacity Challenges for Small Traders

While large institutions grapple with capacity constraints, individual traders face their own set of challenges. 

It’s often harder for small traders to find and exploit true alpha-generating strategies in crowded public markets. 

As a result, many individual traders may opt to:

• pursue beta strategies (indexing to the market, which has lots of capacity), or
• venture into less crowded private markets, such as real estate or private equity, where returns are more process-driven and less dependent on finding and successfully trading market inefficiencies. 

However, these alternatives come with their own risks and drawbacks.

Carefully consider your objectives and risk tolerance.

Methods for Estimating Strategy Capacity

Accurately estimating the capacity of a trading strategy is necessary for both large institutions and individual traders.

(Though it’s less relevant for individual traders.)

Several methods can be used to evaluate the capacity limits of a strategy, each with its own strengths and limitations.

Historical Backtesting

One common approach to estimating strategy capacity is through historical backtesting.

This method involves:

• simulating the strategy’s performance over historical data while incrementally increasing the trade sizes or position levels, and
• making assumptions about how bid-ask spreads and market depth changes

This would have to be customized, as standard backtesting assumes no transaction costs (typically).

But by analyzing how the strategy’s performance changes as the simulated capital grows, traders can identify the point at which returns begin to deteriorate due to factors such as increased market impact or liquidity constraints – especially when conducted over a wide range of market conditions.

Understand that past performance and market conditions may not be indicative of future results, and unforeseen events or structural changes in markets could impact the strategy’s capacity in ways not captured by historical data.

Market Impact Models

Another method for estimating strategy capacity involves the use of market impact models.

These models attempt to quantify the effect that large trades will have on market prices.

They take into account factors such as:

• liquidity
• trading volume, and
• market volatility

Market impact models can be based on empirical data, theoretical models, or a combination of both.

They can help traders estimate the potential slippage or price impact that would occur when executing trades of various sizes.

It allows them to determine the maximum trade size that can be executed without causing excessive market impact.

Their accuracy depends on the quality and relevance of the input data and assumptions used.

Also, these models may not capture all the nuances and complexities of real-world market conditions, which could lead to over- or underestimation of strategy capacity.

“Soft” and “Hard” Capacities

When discussing strategy capacity, it’s important to differentiate between so-called “soft” and “hard” capacity limits.

The capacity of a strategy can be subjective.

For example, if a strategy has a Sharpe ratio of 5 at a $1 million capacity, a Sharpe of 3 at $5 million, and a Sharpe of 1 at $50 million, what is the capacity threshold?

Soft Capacity

Soft capacity refers to the point at which a strategy’s performance begins to decline due to increased market impact or other factors, but the strategy may still be considered viable and profitable.

In contrast, hard capacity represents the maximum level of capital that a strategy can effectively manage before its performance becomes unacceptable – i.e., doesn’t add enough value relative to pre-defined criteria.

For instance, if a hedge fund:

• charges a 2% management fee and 20% performance fee (2/20) on returns above 6% annually, and
• wants to deliver 15% net after fees…
• …that means it needs to deliver about 20% gross (since 20% gross would take 2.8% away for performance fees and 2% from management fees)

So any strategy not expected to deliver 20% per year within acceptable risk parameters may be deemed unacceptable, and cap capacity in order to adhere to that.

On the other hand, if a firm:

• can charge 2/20 on 20% returns on a $1 billion AUM, but
• charge just 1/10 for 10% returns on a $10 billion AUM…

…it may still choose to “go big” because the math works out better on the latter.

Moreover, if that firm can develop a beta product that it charges 0.50% management (and no performance fee) and that attracts $100 billion in capital, that would be much more profitable than either alpha product.

Hard Capacity

This hard limit is typically higher than the soft capacity limit and represents a point beyond which the strategy shouldn’t be deployed.

Traders and portfolio managers will monitor both soft and hard capacity limits.

While operating within the soft capacity limit may be desirable for optimal performance (performance would expectedly decline but in an acceptable way), exceeding the hard capacity limit can lead to breaching their obligations to their clients who expect certain return, risk, and correlation characteristics from what they’re invested in.

Capacity for Alpha Strategies vs. Capacity for Beta Strategies

Alpha strategies, which try to generate excess returns through exploiting market inefficiencies, typically have lower capacity limits compared to beta strategies that track broader market indices.

Alpha strategies often involve niche research-driven opportunities, arbitrage plays, or tactical trading/investing that can become exhausted if more capital flows in.

Alpha is zero-sum.

In contrast, beta strategies can accommodate larger capital inflows due to the liquidity and depth of major equity and bond markets.

Nonetheless, capacity for beta strategies is still finite, as excessive assets can lead to tracking error and implementation challenges.

While companies like Vanguard and Blackrock may have trillions in AUM, even they have limits.

Strategies for Managing Capacity

As trading strategies approach their capacity limits, fund managers and traders use various strategies to manage and maintain their performance.

Here are some common approaches used to address capacity challenges:

Closing Strategies to New Investors

One of the most effective ways to manage capacity is by closing a successful strategy to new investors.

This approach involves limiting the amount of capital that can be invested in the strategy.

This helps in preserving its existing performance potential.

By closing a strategy to new inflows, fund managers can prevent the strategy from exceeding its capacity limits, which could otherwise lead to diminished returns or increased risk.

This strategy is often employed by successful hedge funds or institutional investors that have already attracted significant AUM.

While closing a strategy to new investors may limit potential growth opportunities, it can help maintain the integrity of the strategy and protect the interests of existing investors.

It’s also important to understand that institutional traders/investors typically have leveraged positions, which means their notional amount traded can be high relative to investor equity.

So when someone raises a “$10 billion fund” there’s generally significantly more than that that actually gets traded.

Launching New Funds

As an alternative to closing successful strategies, some fund managers choose to launch new funds that employ similar, but not identical, trading strategies.

An example would be a successful trader taking a strategy that they use in all global markets that’s closed to new investment and launch a new fund that focuses on only the largest developed markets.

This approach allows for continued growth and the accommodation of new capital while avoiding the capacity constraints of existing strategies.

By creating new funds that follow related but distinct strategies, fund managers can effectively increase their overall capacity while maintaining the performance of their existing strategies.

Nonetheless, this approach requires careful management to make sure that the new strategies don’t simply replicate or cannibalize the existing ones.

Launching new funds can be a complex and resource-intensive process.

It can require the development of new trading models, risk management frameworks, and operational infrastructure.

Fee Structures

Another strategy for managing capacity involves the implementation of fee structures that align the interests of investors and fund managers.

One such approach is the use of performance-based fees, where a significant portion of the fund’s fees is tied to its actual performance.

By linking fees to performance, fund managers have a strong incentive to maintain their strategies’ capacity and avoid over-extending beyond their optimal operating levels.

If a strategy’s performance deteriorates due to excessive capital inflows, the fund manager’s compensation would also be adversely affected.

Additionally, some funds may employ higher fee structures for larger investors or those seeking to allocate significant capital.

This approach can help discourage excessive capital inflows and make sure that the fund operates within its capacity limits.

While fee structures alone may not entirely resolve capacity challenges, they can serve as an effective way to align incentives and encourage responsible management of strategy capacity.

Kick Out Investors

Some might raise fees to reduce AUM or they might even kick out existing investors to run their own capital only.

A popular example of this is hedge funds converting to family offices.

This is often done when:

• the partners of their firm have enough savings built up that they no longer need clients/external capital
• they simply want to reduce the level of AUM they run (sometimes their strategy doesn’t work as well due to perceived/actual structure changes in markets)
• they want to reduce stress or retire