The Capacity of Factor Index Strategies: Assessment and Control

Abstract

Capacity measures how much can be invested in a strategy before declining expected returns make competing strategies look more attractive. Existing approaches for measuring capacity are often based on a strategy’s expected return and hence are vulnerable to estimation error. Using the exposure characteristics of factor indexes is an alternative way of gauging the capacity pressure such strategies may be facing. This article discusses different ways of controlling investment capacity in designing a factor index. With careful design, the capacity of a factor index can be improved without significantly compromising exposure to the target factor. Six practical ways are investigated that allow investors to modify their strategies to be capacity-sensitive while still capturing the desired factor exposure: controlling the maximum benchmark multiple, trade size, and turnover and rebalance frequency, alongside the use of staggered and spread rebalancing.