CTA capacity constraints

There are numerous CTAs trading several billions as already mentioned in this thread, so it seems that it is possible.

However, this comes at a cost:

1) In order to accomodate such large amounts, the focus shifts more and more to financial futures, away from the commodity markets which are not liquid enough anymore. Sure, the energy sector etc. is no problem, however sectors like meats, softs, agriculture are a problem, so on a relative basis they can allocate only a small amount to these markets. Hence, these funds offer less diversification than a smaller CTA.
At times this might even play out in their favor (e.g. if the markets they have a higher allocation to - lets say bonds - have strong trends), but in the long run they should have a lower risk-adjusted return than small- to medium sized CTAs (note that too small leads to different problems).

2) Large part of their research is focused on order execution, i.e. how to handle their huge order sizes. For an investor thats actually bad news as the focus is not on improving the systems but just on how to minimize their market impact when managing such large amounts of money.

3) Another problem (to a smaller degree): Large CTAs have started to trade OTC instruments which is another source of risk.

So I would say that the statement of the CTA you mentioned is only partly true and is certainly not professional.
 
Let's say you have a $2 billion commodity pool. You want to allocate 20% into the ags, for example... so $400 million. Of that, you want to maintain a m/e ratio of about 15%... so you should be trading enough agricultural futures to equate to $60 million in margin.

With initial margin of about $2750 (half way between corn/soybean)... you would be holding about 20,000 ag futures when fully invested.

So far today (excluding overnight)... front-month soybean traded 150,000 contracts. Corn traded 220,000 contracts. Wheat traded 60,000 contracts. Total daily volume of about 450,000 futures. (These are only Globex numbers... ag futures in Europe/LIFFE, Asia/China are also very liquid.)

I don't believe it would be difficult, at all, for a CTA managing a $2 billion fund to scale in/out of their agricultural positions when their max position is only about 4% of *daily* volume. (And most have long holding periods.) Think about the size most cash equity hedge fund managers are dealing with... its often many times ADV.

Clearly, at SOME point size does become an issue... and if you're trading lean hog, or some obscure spread 2-3 years out... then size becomes an issue even earlier. But for a commodity pool trading mostly front month, there is quite simply a ton of liquidity. I don't think you have capacity issues at a few billion dollars.
 
They will have no difficulties to accommodate their orders, but still they will have a market impact. Of course, the longer term they trade the smaller the problem, but this means that they are less flexible with their system (i.e. they have to trade longer term due to their size) and they still have to roll their position.

It might not be a problem during "normal" market circumstances, but in a fast move it's definitely harder to switch positions. Of course, their system won't fall apart due to their size, it's just that it will result in a worse performance. And yes - compared to cash equity markets it's relatively easy, even for the large CTAs.
 
Quote from trade2live:

I was talking to a new CTA with a run of the mill trend following strategy (live track record of 14% annualized over past 7 years, on 40+ markets) and he said he doesn't see any capacity constraints for such program until he hits billions in AUM. I don't think so .
For starters as far as I know few CTA's run billions of dollars, and their performance has been rather mediocre over the past 10 years, especially if we remove 2008-2009 and I read CTA's tend to disappoint as they grow in size, which in general seems to be true in my experience .
So is it professional for him to say no capacity constraints ?
More...


What many CTAs seem to do, and this would be our goal as well, as we grow, is simply to trade fewer and fewer contracts per amount of capital.

There's a good interview in Futures Magazine last month with Steve DeCook, I think his name was. Ran a few million, did very well, and quit for a while...
But I remember in the beginning of the interview he said he was more aggressive when he was younger: He traded 1 contract per $25k; now he trades 1 contract per $100k.

I suppose, OP, if you were to extrapolate, a CTA could trade 1 contract per $250k, and so on.

And you're right. Established CTAs have not done as well lately, with a handful of exceptions. Stable, emerging managers can usually outpace their larger rivals.
 
"Hedge-funds: How big is big?"
http://www.math.nyu.edu/faculty/avellane/HFCapacity.pdf

Q
Capacity is the technical word for the total amount of money that can be put to work with a given manager or strategy without deteriorating the fund performance. For example, an expert in biotechnology stocks can use his superior knowledge to invest in that industry, but he cannot invest more dollars than the total value of all biotechnology companies. Most likely, his capacity is only a small fraction of the total value of the industry.

Some strategies and managers have naturally greater capacity than others. Currency trading, in which trillions of dollars change hands daily, has more capacity than investing in the stock market of a developing country. All other things equal, investors tend to favor investing in ``deep markets’’ over ``niche markets’’ because more money can be put to work. A seasoned New York trader put it this way: `` it is useless to have a good trade idea if there is no one to trade with. You have to find good trades that can actually get done’’.
UQ
 
Capacity Constraints and Hedge Fund Strategy Returns
http://intranet.sbs.ox.ac.uk/tarun_ramadorai/TarunPapers/CapacityConstraints_October2006.pdf

Q

We attempt to uncover whether capacity constraints in the hedge fund industry are responsible for the recent decline in the alpha of hedge fund strategies. We find that for four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha.

Taken together, our results suggest that capacity constraints do exist at the level of hedge fund strategies, and are likely to be a concern for investors going forward.

UQ
 
Can Capacity Constraint Explain Introduction of New Hedge Funds?

http://www.efmaefm.org/0EFMAMEETINGS/EFMA ANNUAL MEETINGS/2011-Braga/papers/0152_update.pdf

Q

In this paper we test the idea that hedge funds‟ capacity constraints may play a significant role on the decision of fund families to open a new hedge fund. Our empirical analysis shows that fund families‟ propensity to open new funds increases with degree of capacity constraint faced by existing funds of the families. We argue that hedge fund families face diseconomies of scale because of the non scalability of their investment strategies and as their existing funds approach the critical size, fund families prefer opening a new hedge fund rather than allowing the existing funds to grow. We find that the strategy of starting new hedge funds to divert fund flows from an existing fund works well as fund flows to the existing fund decreases, and that the introduction of new funds also lead to an improvement in the performance of the existing funds of the same family.

UQ
 
http://www.efinancialnews.com/story/2010-01-29/bluecrest-nears-capacity-for-hedge-fund

Q

BlueCrest nears capacity for $9bn hedge fund

Harriet Agnew
29 Jan 2010

BlueCrest is considering closing one of its best performing funds to new investors in a sign that the sector has experienced a marked turnaround in fortunes, with investors looking to invest money into established blue-chip hedge fund managers.

The $17.2bn (€12.3bn) hedge fund manager is considering closing the $9bn systematic BlueTrend fund , which uses computer-driven models, when it hits $10bn, according to investors.

The fund, which is managed by Leda Braga, returned 43% in 2008, when many of its peers took bad knocks to performance during the financial crisis, and was again up 4.3% last year, investors said.

The move comes after Philippe Jabre, founder of Geneva-based Jabre Partners, this week said he planned to shut his flagship Jabre Multi-Strategy fund to new investors to protect returns. The $2bn fund will hard close for two years when it reaches $2.5bn, after returning 85% in 2009, according to investors.
UQ
 
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