Strategy Capacity

A recent Verdad Capital newsletter, Dan Rasmussen points out that it is impossible to scale value investing as defined in academia. Almost all of “value” ETFs and actively managed funds are completely avoiding the cheapest stocks (high book-to-market) while instead owning primarily stocks that are more expensive (low book-to-market).

And what explains this puzzle? Strategy capacity.

The cheapest stocks are disproportionately small in terms of size and volume. This means that an active manager looking to choose, say, the best 40 of these stocks would be unable to manage more than $200M or so. The average small value fund tracked by Morningstar has $1.3B of assets under management. It is close to impossible to deploy that amount of capital exclusively in the cheapest two deciles of the stock market.

This is true for Indian mutual funds as well. Most managers claim to be “value” investors while actually hugging the index with a GARP/momentum tilt. Given the size of most of these funds, there is no way they can invest in value.

Strategy capacity should be one of the questions investors should ask of their fund managers/advisers. Especially advisers of direct equity portfolios who do not know the aggregate exposure that their subscribers have across portfolios.

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