In capital markets, size matters a lot, even more than you probably think. It could define not only the assets you could trade, but also your buying and selling strategy.
If you manage 200 million and your average allocation is 5%, you are very limited to the type of stocks you could engage with. With an average allocation of 10 million dollars, you cannot afford to by a ten-dollar stock that trades 200k shares a day. Even if this $10 stock trades 1 million shares a day, you would have hard time buying 100% of its daily dollar volume without getting substantial slippage. This is why we say that when elephants dance, they leave traces. When big funds buy, they show their hands, they reveal their intentions. It is almost impossible for a big fund to buy its entire position in a mid-cap in one day.
Because of liquidity constraints, large funds:
1) cannot swing-trade. It takes several days/weeks to establish a new position and just as many to sell one.
2) cannot own individual small cap names, because they cannot establish position that is big enough to make a difference; guess where the best performing stocks come from, every single year.
3) sell on strength when there is enough demand to absorb their supply. If they wait to exit their entire position on a trend break (weakness), they will get a lot lower price as liquidity tends to magically disappear just when they need it the most.
4) buy established trends on weakness (pullbacks) or accumulate in anticipation of a a new trend – they realize that they won’t be able to build a big enough position when the stock of interest breaks out.
5) love market corrections. The two most favorite words of many value investors are forced liquidation. They live for that once a 2-3 years deep market pullback that allows them to accumulate positions of interest on the cheap. Momentum investors also embrace deep market corrections as they reset many bases and facilitate the discovery of big future winners.
Smaller market participants have an incredible advantage.
We could chose to wait and buy a breakout, because we don’t have the liquidity constraints to build our positions. By waiting for a breakout, we optimize our capital allocation – we are making sure that we are invested only in names that are already moving in our direction. We could be in and out of a name inside a day.
Or we could buy a trending stock in anticipation of a breakout, knowing that institutions are likely to support it. Bull flags are typical trend continuation patterns. Do you know how they are formed? Basically the process is the following:
1) there is a catalyst (earnings or price related) that causes a stock to break out;
2) let’s say that in our example, our stock of interest runs from 30 to 40 in a week;
3) it is normal to expect some form of mean-reversion after such an explosive move – either through time or through price
4) Institutions that are not willing to chase, could just put a big bid at 38, so every time this particular stock drops to 38, supply will be absorbed.
5) The stock will remain in this 38 to 40 range until the entire supply is absorbed and there is enough demand to push the stock higher.
We don’t need that much liquidity to exit. We could sell on strength or we we could sell on weakness, when there is a clear technical indication that the trend is over.
When people judge the performance of billion-dollar hedge funds, they need to realize how constraint those funds are in terms of opportunities. Which brings the question – why would you even consider allocating money to what is essentially a big huge asset gatherer? You are buying a ticket for almost guaranteed under-performance.
