Constraints in Asset Allocation: Asset Size

The Abu Dhabi Investment Authority portfolio was over USD 828,000,000,000 at the end of 2015. That's some serious investment capital. If you were managing such a portfolio, what issue would you face if you were allocating assets to the S&P 500 Global SmallCap Index that had a total market cap of USD 15,600,000,000?

That's not it. The index is definitely not too large for a position.

Clearly, yes! The index is just way too small for the Abu Dhabi Investment fund to take a meaningful position. The size of the fund is actually a constraint in asset allocation; it limits the asset classes available to the investment fund.

No. There are probably lots of securities in the index, but that wouldn't stop you from investing in it.

So as you can see, asset size constraints can run both ways: from having too much capital, all the way having too little capital. These capital sizing issues also impact external asset managers. For example, as external funds grow in size, asset managers run into significant issues in their ability to trade, execute, and pay for their strategy. Why would trade execution be impacted by asset fund size?

That's not it. That's a cost issue, not an execution issue.

You got it! Trades will become so large that price concessions must be made in order to fill the trade. So buys would pay a higher price, and sells would receive a lower price. In addition, asset managers may try to earn returns outside the fund's core philosophy or spend additional time working through bureaucracy that the additional investment staff provides.

No. External asset managers aren't market makers, so that's not a benefit.

So all together, external asset managers don't really benefit from additional asset size. But asset owners actually do. For example, while larger investment funds will run into sizing constraints for certain asset classes, benefits of scale can also be achieved by using the size advantage to the fund's favor. This can include the ability to take additional illiquidity risks like real estate or private equity investments and also potential cost savings from the ability to negotiate lower fees. Speaking of fees, as larger investment funds continue to grow, their governance costs essentially become fixed, while assets continue to rise. Take a pension fund, for instance. How will this impact the "per beneficiary" cost of governance?

Not quite. The cost is fixed, not variable.

That's not it. It's a fixed cost, so as assets grow, the fees per beneficiary change.

This is especially true when it comes to allocations to active managers. Some active large-cap developed equity market and hedge fund managers, for instance, will offer alpha, or excess returns, that entices large investment funds. But some of these funds might be so large that the active equity exposure or hedge fund exposure must be broken down among several managers. Keeping in mind that alpha is rare and hard to generate, what problem do you think extremely large funds face when active management mandates are broken apart?

Exactly! Instead of receiving alpha, the super-large fund will just receive an index return, because some managers will outperform, and others will underperform. So essentially, the fund is better off in a low-cost index, instead of paying active management fees.

That's not it. Alpha generation isn't easy.

No, actually. Some managers will probably outperform, while others will underperform.

On the other hand, it can be a similar situation for smaller investors, who don't have the capital necessary to meet minimum investment requirements of certain funds. More so, small investors lack the ability to sufficiently govern some types of investments, as it can take a staff of investment professionals to effectively evaluate certain types of securities. This basically leads small investors to broaden their overall exposure while reducing the number of portfolio holdings. What's another way to describe this strategy?

No. Even index fund exposure will increase the number of holdings.

Well, no. Small investors don't want to hold individual positions because of the cost.

Excellent! Small investors will shift to commingled funds, which will combine various strategies to give the investor a smaller number of holdings while maintaining diversified exposure. Basically, commingled funds can help smaller clients gain valuable diversification if allowed by the investment policy statement.

Right. Since the governance cost remains the same, the pension fund will experience economies of scale and have a lower beneficiary cost over time. This then allows the fund to invest more in investments that provide a return for economies of scale (like illiquidity premiums), like alternative investments.

In comparison to institutional pension funds (which are mainly massive funds), most individual investors are small, which is why governments have stepped in with regulations. In the United Kingdom, for instance, investors in private funds must prove that they have historical experience with dealing with large transactions, handling a portfolio of a certain size, or working in the financial sector. Two of the three criteria must apply. The United States and Hong Kong also have requirements regarding experience, total wealth values, and investment assets. Why do you suppose governments would require such criteria for investors?

That's not it. Investing means taking risk, and governments shouldn't try to prevent losses.

No. Investment regulations are about protecting investors, not taxation.

To summarize: [[summary]]

That's right! Regulations are put in place to ensure that individuals are able to understand and evaluate the risks associated with private investments. Taking large risks in illiquid securities is allowed, but governments want to ensure that investors aren't taking risks that they don't understand.

The index is too large to build a position

The index is too small to build a position

The index is too broad to build a position

Trades will be smaller in size but more frequent

Trades are large, which increases the price impact

Trades can help establish a market for the security

It will be lower

It will be higher

It's not going to change

The active class mandate becomes an index

The active class mandate quickly outperforms the rest of the portfolio

The active class mandate loses value in relation to the rest of the portfolio

Using commingled funds

Using broad index funds

Using individual securities

To prevent investment losses

To confirm that investors will pay taxes on the gains

To ensure that individuals understand the investment risk

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