Investors now are generally aware that portfolios have a certain level of capacity, but because it has become so well-known the details behind the practice can get lost. The overarching rationale for closing a mutual fund, separate account or other vehicle is to preserve the investment discipline which allows the philosophy and process to create handsome returns. It prevents the degradation of performance.
To explore this topic, we propose a very simple model to use as an example. Say an investment manager has a very systematic approach: he purchases only 10 companies, with an equal weighting, with an average market cap of $1 billion (and low disparity in company size). Further, let us suppose he is uncomfortable holding more than 10% of any company’s stock. What is his capacity? Holding 10% of a $1 billion company’s stock would be $100 million. Ten holdings of $100 million is $1 billion. Note that after he reaches this threshold to invest more money he would have to modify one of his tenets by adding an 11th stock, moving to larger companies, or owning more than 10% of a holding’s shares.
Our calculation for the micro-cap portfolio is relatively similar. In calculating his portfolio’s capacity, Lead Portfolio Manager David Maley starts with the number of holdings allowing reasonable diversification but deep knowledge of each name—arriving at 40 stocks. He uses an average market capitalization of roughly $200 million (based on portfolio history) and assumes an equal weighting (2.5% of each name). At $600 million in assets, that implies an average ownership of 7.5% (40 X $200 X .075 = $600 million). Given that we are long-term investors, we feel that closing the portfolio to new clients and new money just before that level is reasonable. It’s worth noting these numbers jibe with the current portfolio. Presently, for instance, holdings run from a low market cap of $20 million to a high of approximately $800 million with a weighted average just over $200 million. The 40 position sizes range from nearly 6% down to just under 1%, with an average position size around 2.5% of assets.
All along our plan has been to close the portfolio to new investors as we approach that level. Because the Ariel Micro-Cap Value Product has reached $500 million in investments and commitments, we are no longer marketing it to new prospects. David anticipates closing the portfolio to all investors at $600 million—reserving the right to do so somewhat earlier or later based on the portfolio’s actual shape at the time. We should note that David runs both micro-cap value as well as the similar but higher-cap Ariel Discovery Fund (which currently remains open). To the extent there is overlap, David will examine the total capacity of each individual stock as well as each strategy in deciding position sizes.
Ariel Investments has performed similar calculations on all of its portfolios and has capacity guidelines in place for all of them. At present, only the micro-cap portfolio is nearing its capacity limit. As other portfolios reach their thresholds, we will sharpen our pencils and determine precise limits before closing the portfolios to new investors and investments.
The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Investing in equity stocks is more risky and subject to the volatility of the markets. Investing in micro-, small and mid-sized companies is more risky and more volatile than investing in large companies.
Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current summary prospectus or full prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or click here. Please read the summary prospectus or full prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC.