Investment "capacity" - Ethics Standard V(B) Communication with Clients

I’m spending too much time on this stuff.

Regardless, let me ask the forum for clarification:

In the Ethics Standard V(B), the institute calls out Identifying Risks and Limitations associated with our analysis/recommendations (page 139, bottom). They also suggest we discuss any limiting factors, such as investment liquidity or investment ‘capacity’.

They define capacity as “Capacity is the investment amount beyond which returns will be negatively affected by new investments.”

What are a few examples of an investment which has this type of limiting factor?

Mutual Funds.

Think about a micro-cap mutual fund that has 500B in AUM. How can they possibly invest in microcap companies with that much in AUM - rule of thumb is that your AUM as a fund shouldn’t be astronomically more than the market cap of the companies you are buying. If a micro cap stock is defined by say 100M then a .02% investment of the funds assets would totally buy up the entire company.

To add, there is emperical evidence that having more AUM in funds leads to subpar performance. Let’s say a fund goes from 100M AUM with 1 PM and 2 analysts to 10B AUM in a matter of 6-12 months with the same staff. The amount of time it would take to hire more analysts, etc. to help manage that money would be longer than the 6-12 months. Therefore you would have a capacity issue in the sense that the team of 3 couldn’t possibly handle this work load properly. These sorts of items should be disclosed to clients.