1. Don Hamson Head of Active Australian Equities Capacity When is enough, enough?

2. Australian Equities Managers Assets Under Management As at June 30, 2004 Source: InvestorInfo Limited

3. Advantages and Disadvantages of large AUM Advantages of being large Economies of scale in research capabilities Leverage over fixed costs of trading Greater voice with companies Disadvantages Increased trading costs Loss of anonymity Limits to the size of holdings

4. Australian Corporations Law requirements Section 671B(1A) – Substantial Holding Statement at 5% voting capital And from then every 1% movement Section 606 – Prohibition on acquisitions Cannot acquire >20% issued capital Unless satisfy an exception, one of which is launch a takeover offer

5. Regulatory Impacts on Strategy Assets Under Management Strategy Assets under management 1% = 5% at company number 1% = 20% at company number $500m199n/a $1,000m192n/a $5,000m110188 $10,000m71148 $15,000m57124 $20,000m45111

6. Possible impact of regulatory requirements Substantial shareholding reveals signal Rest of the market may “front run” v No academic evidence as yet Getting in is easy. Getting out on the other hand… v Overhanging stock

7. Trading costs Brokerage – possibly decrease with volume Bid/Ask spread – increase with volume Market impact – increase with volume AUM1% trade Time to trade BHP Time to trade CGF $1b$10m~20 min3 days $10b$100m3.5 hrs1 month Note: Assumes 100% of traded volume. If only 20% multiply time to trade by 5.

8. Days to trade a 1% position Source: IRESS Cheap to Trade Expensive to Trade Cost increase s as AUM increase s

9. What do managers do as they get bigger? Trade less Trade at a slower rate Take smaller relative positions Limit the total positions to <5% or <20% Result Reduces information ratio, active risk or both

10. Determining capacity No fixed method for determining strategy capacity Two possible definitions Return based Wealth based

11. Definition 1 Capacity is the strategy assets under management at which net alpha is at a maximum. Net alpha = Gross alpha – Trading Costs Gross alpha is the “on paper” performance potential

12. Example Investment strategy Gross alpha = 3% per annum (on paper) Turnover = 65% per annum Trade monthly Trading cost model 0.20%, plus Additional 0.20% for every $1b of annual trading volume

13. Trading costs increase as Strategy AUM increases Annual Turnover = 65% Monthly trading - $27m Monthly trading - $1,083m Source: SSgA

14. Performance declines as Strategy AUM increases Break even 1. Gross Alpha 2. Trading Costs 3. Net Alpha Source: SSgA

15. Impact of Strategy AUM on Performance Costs increase with turnover and AUM Dependent on the underlying market Performance impact is one way Always reduces return Breakeven point Beyond which net return is negative

16. Definition 1: Optimal Capacity Optimal solution Don’t manage any assets

17. Investor perspective Discourage manager from taking on too many assets Small assets = Best returns But Alpha  Research  Resources  Revenue What fee would a manager charge Only hire small managers A large number of small managers Diversification problems Identifying enough skillful managers

18. Definition 2 Capacity is the strategy assets under management at which wealth creation is at a maximum Wealth = Net Alpha x AUM Example: Wealth Created = 2.5% x $1,000b = $25m

19. Wealth changes as Strategy AUM increases Adapted from: Perold, A.F. and Salomon, R.S., The Right Amount of Assets Under Management, Financial Analysts Journal, May-June 1991 Wealth Maximising AUM

20. Definition 2: Optimal Capacity Optimal solution The point at which the wealth creation potential of a strategy is at a maximum This doesn’t mean that performance is at a maximum Early investors get the good returns Performance is diluted at the margin

21. Conflicting interests between manager and investor Management fees of 0.30%pa Investor wealth Manager wealth Source: SSgA

22. Performance fees help to align the interests Manager wealth with fixed fees Manager wealth with performance fees Source: SSgA Performance fee = 20% positive performance

23. Capacity? Definition 1 Stay small to keep return Definition 2 Grow to wealth maximising point Solution Somewhere in between

24. Investor responses to the capacity problem Demand an analysis of capacity Implement monitoring procedures for process capacity Beware the double count Align interest Performance fees Still requires monitoring The ultimate sanction

25. The “double count” Problem Make a nominal change to the process and call it a different strategy Determine capacity for the two strategies separately Solution Capacity is specific to a set of alphas Different versions may have different capacity impacts

26. “Double count” example SSgA Active Australian equities Single set of alphas Multiple strategy versions Strategy versionAUMCapacity impactCapacity take up Enhanced5000.25:1125 Long only1,5001:11,500 Alpha Plus1,0002:12,000 Long/Short3503:11,050 2,3504,675

27. How can a manager increase capacity? All other things being equal Lower turnover increases capacity v But alpha potential maybe related to turnover Greater alpha increases capacity v Research effort Lower transaction costs increases capacity v Need for skillful trading Increase in market liquidity increases capacity v Need for regular review

28. Capacity: When is enough, enough? Increasing AUM reduces performance Investor and manager incentives may not be aligned Need to monitor capacity and its impact Performance fees can help align investor/manager interests