CHAPTER 15
Practicalities of Size, Liquidity, and Capacity
Many argue that diversification may be the only free lunch in finance. Diversification can come in various forms, including varying investment styles, exposures to risk factors, choice of sectors/markets and asset classes, speed of trading, and many other parameters. Chapter 3 introduced four key differentiators in trend following systems: risk targets (leverage), market allocation, trading speed (holding period), and directional bias. Chapter 11 discussed return dispersion by examining both position sizing and sector capital allocations. Chapters 12 and 13 presented a framework for analyzing the importance of construction style. In each of these discussions, the practicalities of size, capacity, and liquidity was mentioned but not examined in detail. This chapter examines the diversification benefits of trend following as a function of size, capacity, and liquidity. First, size is examined as a function of capital allocation and trading speeds. Second, the diversification benefits of adding less liquid markets are discussed.
■ Does Size Matter?
As funds grow in assets under management, there are several important considerations. First, capital allocation may be constrained by market liquidity and volumes imposing capacity constraints on managers. This will effectively require larger funds to slant their allocations based on market size similar to market capacity weighting. Second, trading speeds will be limited to ...
