MFSWhite® Capability Paper Series Focus MonthApril 2015 2012

Authors CAPACITY : A KEY RISK MEASURE

IN BRIEF Michael T. Cantara, CFA Head of Global Client Group • Capacity management is an integral component of the investment process. • Preserving alpha-generating capability for clients is an overarching guiding principle in the review of capacity at MFS®. • Capacity is considered under the rubric of risk and evaluated in a systematic semiannual process along with other portfolio risks. Joseph C. Flaherty Jr. • The firm’s approach to capacity management includes quantitative Chief Investment Risk Officer analysis and qualitative assessments as well as additional non-portfolio considerations. • The steps taken to manage the growth of assets in MFS’ Global Equity strategy since 2006 present a clear case study on capacity management decisions.

John E. Stocks, CFA Quantitative Research Analyst Success in leads to a well-known conundrum: how to best manage increases in assets under management (AUM) while continuing to generate value-added alpha for clients.

A growth in AUM may make it more difficult to implement a strategy by imposing certain costs and impediments, such as liquidity constraints, potentially higher transaction costs and client-servicing requirements, as well as the need to ensure Ravi B. Venkataraman, CFA adherence to the strategy. diversification across multiple strategies and Global Head of Consultant Relations investment teams is another important consideration when evaluating the capacity of individual investment strategies. This is key to ensuring a sustainable , which in turn impacts individual product performance. BUILDING Capacity can be managed in various ways, including with the implementation of BETTER BETTER SM product closures, which are designed to protect the interests of existing clients by INSIGHTS ® limiting further inflows. In this case, we are referring to both clients in the strategy INSIGHTS of interest as well as clients more broadly in strategies that may overlap with the APRIL 2015 / CAPACITY MANAGEMENT

product in question. Preserving alpha-generating capability for the MFS risk review process. In addition, capacity is examined existing clients is paramount in our view, and is at the heart at the firm level on a periodic basis. Product risk profiles and of capacity management. It is in this context that capacity investment style are monitored on an ongoing basis to management is viewed as an integral component of risk ascertain whether a growing asset base is leading to shifts in management at MFS. a product’s risk profile or style. Trading patterns and transaction costs are also monitored to determine whether While there is general agreement among asset managers and rising assets are making a strategy more difficult and their clients that products need to be closed for capacity expensive to implement. reasons, there is little consensus on how capacity should be measured. Various academic and industry studies have offered a number of quantitative tools to help determine product Exhibit 1: MFS’ approach to capacity management capacity; however, these approaches are sensitive to the underlying assumptions made and none is definitive. Not only is capacity hard to measure, it is also a function of current Non-portfolio considerations market conditions and the characteristics of a given strategy. Certain asset classes are inherently more capacity constrained than others. Portfolios invested in large-cap US equities have significantly more capacity than portfolios invested in either small-cap or emerging market equities. Highly concentrated Quantitative CAPACITY Qualitative portfolios (e.g. 20-stock portfolios) generally have less model REVIEW assessment capacity than more diversified portfolios, depending on the liquidity of stocks included in the portfolio. Portfolios with high turnover require greater market liquidity and therefore have less capacity than portfolios with lower turnover that Guiding principles can patiently over longer holding periods. One should bear in mind that all these parameters interact with one The firm’s approach to capacity management is guided by another and market conditions change over time, so portfolio these important principles: characteristics must be fully examined before applying Protecting clients’ interests – Capacity management is generalizations about capacity. an integral part of MFS’ client-centred strategy. We are In this paper, we outline MFS’ approach to managing capacity committed to continually monitoring and prudently in equity portfolios in some detail to illustrate the firm’s managing product capacity consistent with the firm’s philosophy and considered methodology. We also provide commitment to maintaining product integrity and adding information on the product restriction decisions made with sustainable value for our clients. At the core of the firm’s regards to the Global Equity strategy as a case study. The strategy is a commitment to ensuring that existing clients are way capacity is considered from a fixed-income portfolio not adversely impacted by the rising costs and declining perspective is addressed briefly on page 8. performance that can result from capacity constraints. Aligning compensation – Portfolio managers at MFS are not MFS’ approach to capacity management paid based on AUM but rather on their contribution to the MFS employs a combination of quantitative analysis and firm, viewed through the prism of long-term investment qualitative assessments to help measure and manage capacity, performance and collaboration with colleagues. This ensures and also takes other non-portfolio considerations into that the portfolio manager incentive structure is aligned with account such as idea generation, business diversification and clients’ interests and the long-term performance of portfolios. portfolio manager non-investment responsibilities (see Exhibit This alignment of interests is an important principle in our 1). Discussions regarding capacity focused on the individual view as it ensures that portfolio managers are not incentivized strategy level take place formally every six months as part of to take on more assets than may be prudent, but rather the reverse.

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Considering capacity management a risk measure – At MFS, The two primary factors we use to set ownership limits at the capacity management is evaluated under the rubric of risk and, security level are: as such, is a component of the semiannual risk review process, • percentage ownership of average days trading volume (ADV) which involves an in-depth examination of portfolio risks with • percentage ownership of the shares outstanding of senior management. Capacity management is reviewed in this a company context along with other risk measures. The semiannual risk review ensures there is a systematic process to monitor and Capacity model detailed measure capacity for every equity strategy at MFS. The capacity model includes the following steps:

Preserving alpha-generating capability for existing 1. Determine security/issuer level ownership constraints clients is paramount in our view, and is at the heart for the entire firm for all securities held within the of capacity management. It is in this context that portfolio being measured capacity management is viewed as an integral Ownership constraints are set by the percentage of component of at MFS. shares outstanding and the percentage of average days trading volume (ADV). Quantitative capacity model • Percentage of shares outstanding = MFS aggregate The capacity management process begins with a quantitative shares/total shares outstanding framework, in which product capacity forecasts are generated The calculation of the percentage of shares outstanding based on factors such as share ownership and trading takes place at the equity issuer level and accounts for volume, and considering the holdings overlap across multiple multiple listings, share classes, ADRs/GDRs, etc. We model MFS products. Sensitivity analysis is performed around all of this limit at a 10% threshold for all securities, although the assumptions inherent in the quantitative analysis to we may own up to approximately 15% in some stocks. generate a multidimensional grid of capacity estimates. • Percentage of ADV = MFS aggregate shares/90-day The basis of the capacity model is to establish the constraints average trading volume on replicating an existing portfolio at increasing levels of We use three base scenarios to assess the liquidity of AUM, i.e. determining the aggregate assets that can be ownership: 5 days, 10 days and 15 days of ADV. The managed in the strategy as it is positioned at the time. In the number of days trading in this calculation refers to the model, we do not attempt to adjust for market appreciation, total shares owned over the period at 100% of volume.1,2 make portfolio positioning assumptions or account for how 2. Calculate the number of incremental shares available managers might react in the face of capacity constraints. to MFS Ownership limits are initially set for the overall at For each security in the portfolio, we calculate the the security and issuer level. As a multistrategy firm with difference between the aggregate shares currently cross-ownership among strategies, exposure needs to be owned by MFS and the total shares set at each ownership monitored across the complex. This leads to the need for constraint level defined above. We call this the incremental certain product share assumptions. The product share figures shares available for purchase. are then applied to incremental available securities or the modeled growth in assets.

1 This should not be confused with the number of days we expect it to take to liquidate a position. In other words, when we set the limit at 10 days volume, it does not mean we are setting a limit of 10 days to liquidate a position. In order to measure liquidity on the basis of time, we would need to add an estimate of a given participation rate. Typical participation rates on larger orders range from 10% to 25% of ADV but may be significantly larger or smaller depending on the market conditions for a security on a given day. 2 In addition, we make numerous adjustments to get accurate estimates of the trading volumes. This includes, for example, aggregating the trading volumes across multiple listings such as ADRs, GDRs, dual-listed Canadian stocks, etc., in order to capture the liquidity that is actually available to our traders. We also source volume for certain securities from nonstandard sources. For example, when Russian and Thai securities report no volume for a particular share class, we have a process for identifying these holdings and sourcing the correct volume from Bloomberg.

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For example, if MFS currently owns 100,000 shares of ABC 5. Run the analysis for the various scenarios of product company and the minimum of 10% shares outstanding or share and percentage of ADV 10 days trading volume is 250,000 shares, as a firm we The model then runs an iterative process to find the may now purchase 150,000 more shares before hitting AUM, when 20% of the positions by weight are in our limit. securities which have breached the assigned incremental 3. Assign a range of product share assumptions and shares. The output is a matrix of AUM capacity estimates calculate shares available to purchase for this single for each scenario. strategy An example of the capacity model output is provided in We will assign a range of product share assumptions, Exhibit 2 below. In this case, a portfolio with a current which are generally related to the current average AUM of $10 billion was considered. Assuming a 30% product share. These are sometimes adjusted to take product share for this portfolio, the capacity model account of perceived changes in the product opportunity suggests that assets could range from $18.8 billion under going forward. a 5-day trading volume constraint to $55 billion if the In each case, we determine the number of shares available trading volume constraint is set to 15 days. For a given for the particular strategy to own given the overlap and number of days trading volume, increasing the product internal allocation with other strategies. Following on from share percentage also increases the capacity estimates, the example above, if the firm can buy 150,000 more though to a lesser degree than when one varies days shares of ABC company, in a 25% product share scenario, trading volume. This highlights the point that capacity we would calculate that this strategy could purchase estimates are always a range and never a single number. 37,500 incremental shares in ABC company’s stock. The table and chart below illustrates the way in which the model produces various capacity ranges based on the 4. Determine what percentage of the portfolio to replicate various inputs and constraints imposed in the model. without breaching any of these ownership ‘limits’ We can approach this in a couple of different ways. One Exhibit 2: Example of capacity model output matrix for way is to ask ourselves how much of a portfolio we are commingled portfolio willing to own in securities where MFS has a significant Assumptions: ownership in terms of average trading volume or shares Replication of portfolio: 80% Max: MFS ownership % shares outstanding: 10% outstanding. The other way is to say that we want to be Strategy current AUM: $10 billion able to immediately replicate a certain percentage of the Product share Days Trading Volume (ADV) portfolio so that when future assets come in the door, the 5 days 10 days 15 days portfolio managers have some implementation flexibility, n 20% 17.8 30.0 43.5 but not to the point of deviating from the strategy. n 30% 18.8 35.5 55.0 We have been using an 80% immediate replication rate, n 40% 19.6 40.0 66.0 which means that we allow for 20% substitution. In practice, MFS equity portfolios have been replicated at much higher rates and typically fully. Further adjustments 70.0 are made to the model depending on whether the assets are held in commingled or separate accounts. Commingled 50.0

accounts, which benefit from the base of existing assets, AUM 30.0 will have greater capacity for incremental flows than a full funding of a separate account under this approach. 10.0

40% 15 days 30% 10 days 20% 5 days Product share ADV Source: MFS.

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Quantitative example Exhibit 3: Replication positions at varying AUM for The sensitivity of the quantitative model outlined to changes Portfolio A in the input variable assumptions can be illustrated using the 100% following example of a large-cap US equity portfolio (Portfolio A). The first test involves replicating Portfolio A at increasing 90% asset levels, then examining trading volume and percent of outstanding shares owned for each position in the portfolio. 80% In this case, we limit aggregate MFS ownership of an Assumptions: Replication positions individual stock to 10 days trading volume and 10% 70% Ownership % = 10% Trading volume = 10 days of the company’s outstanding shares, and assume that Product share = 30%

Portfolio A’s product share percentage is 30% (see Exhibit 3). 60% The chart shows the proportion of Portfolio A that can be 15 20 25 30 35 40 45 50 55 60 Future assets ($ billions) replicated as assets grow under the constraints stated. In this Source: MFS. case, the 80% replication level is reached when assets are approximately $35 billion. Exhibit 4: Replication positions at varying trading In the second test, Exhibit 4, we assume that Portfolio A is volume constraints for Portfolio A fixed at assets of $35 billion, product share allocated to the portfolio is fixed at 30% and ownership of outstanding 100% shares is limited to 10%, while we reduce the number of days trading volume we are willing to hold. In the graph 80% below, we show that the percent of Portfolio A that can be replicated decreases as the days trading volume constraint 60% is tightened. Assumptions: 40% Ownership % = 10% positions Replication positions Product share = 30% In the third test, Exhibit 5, we keep the size of Portfolio A Future assets = $35 billion fixed at $35 billion, the days trading volume constraint fixed 20% at 10 days and the ownership of outstanding shares limited 19 17 15 13 11 9 7 5 3 1 Days trading volume to 10%, while varying the product share constraint. In this Source: MFS. example, only 85% of the portfolio can be replicated even if Portfolio A absorbs all available liquidity, i.e. if it assumes 100% of the product share. Exhibit 5: Replication positions at varying product share constraints for Portfolio A Qualitative review 100% The capacity analysis described can potentially lead to a wide range of capacity estimates largely because capacity models tend to be driven by the assumptions employed 80% (i.e. number of days to establish or exit a typical position, strategy overlap, etc.). In addition, to arrive at more accurate estimates of trading volume we make adjustments to 60% Assumptions: Ownership % = 10% Replication positions standard reported volumes by, for example, taking account Trading volume = 10 days of multiple listings, the fragmentation of the European Future assets = $35 billion trading market and volumes traded on alternative less- 40% 100 80 60 40 20 transparent trading platforms. Product share Source: MFS.

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For these reasons, qualitative input from portfolio managers Overlap in strategies – The capacity considerations related to and the trading desk regarding the ease or difficulty strategy overlap across the firm is also part of the risk review associated with implementing the strategy and maintaining process. The product share assumptions used in the capacity the investment style is extremely important. model may be revisited in this context. The capacity model is discussed as part of the semiannual risk review process at MFS, and it is in this context that a Capacity estimates are always a range qualitative review of the matrix of capacity estimates takes and never a single number. place. The broader risk measures prepared for the review contain additional information that helps put the portfolio Non-portfolio considerations in perspective in terms of the risk profile and portfolio The capacity review comprises the quantitative and qualitative characteristics, as well as trading costs and performance. portfolio considerations outlined above as well as additional Trading costs, turnover, style consistency and overlap are non-portfolio factors such as those listed below. some of the elements related to capacity that are examined in detail in the risk review alongside the capacity model output. Idea generation At MFS, the global research platform forms the backbone Trading costs – Trends in trading costs can be an important of the firm’s investment idea generation. Analyst opinions, source of information with regard to how the AUM base expressed in the form of a ratings system, continue to be the may be impacting transaction costs and potentially reducing dominant source of new ideas for all our client portfolios, the manager’s ability to add alpha. However, it should be regardless of asset class or style. The platform has been noted that trading costs are also a function of the market strengthened and expanded in the past several years by environment, tend to vacillate for a variety of reasons and additional resources and the opening of new investment may not be indicative of capacity constraints. In general, the offices in Hong Kong, São Paulo, Sydney and Toronto in centralized risk management platform employed at MFS order to exploit the growing universe of investment provides a broad, effective lens with which to evaluate trading opportunities globally. We continue to be cognizant of costs and other risk measures. investment idea generation as we evaluate capacity decisions, Turnover – The longer-term investment time horizon at MFS given that expanded research coverage allows for greater means that turnover for the firm’s strategies is generally on firmwide capacity. the low end of the spectrum. This is as true for the strategies Business diversification with low AUM as it is for those with higher AUM. Turnover is Diversifying assets across multiple strategies is another also viewed in concert with liquidity risk, in that lower important consideration in evaluating the capacity of turnover strategies can take on more liquidity risk. For individual investment strategies. MFS believes that example, even at a higher cost per trade, incrementally higher diversification translates into long-term stability for the firm, trading costs may not have a significant impact on a portfolio in part by also allowing for broader investment talent with turnover of 15% compared with a portfolio with contributions, and for these reasons actively manages the turnover of 100%. business risk associated with product concentration. Style consistency – This encompasses a number of elements Portfolio manager time constraints like name count, active share, average market capitalization Portfolio manager non-investment responsibilities are also a relative to an index, growth/value style drift and any other consideration when capacity is under review. While we seek changes in portfolio investment characteristics. In general, any to maximize value added for our clients by using institutional significant changes that cannot be rationally explained by portfolio managers and investment product specialists to market dynamics would come under the spotlight as part of support the client base so that portfolio managers are able the risk review. It should be noted, too, that style consistency to focus on managing investments, new business often is examined as a key risk measure on an ongoing basis. brings with it additional portfolio manager marketing and service requirements.

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Exhibit A: Active share – GLOBAL EQUITY CASE STUDY MFS Global Equity

90%

In April 2006, the decision was made to soft close the Global Equity strategy to 88%

new separate accounts. Pooled vehicles for new and existing institutional 86%

investors remained open until December 2011, when institutional pooled funds 84%

were closed to new accounts. In March 2013, further restrictions for separate 82%

account clients were announced, with contributions from then-current separate 80% account clients only being accepted until September 2013. The vehicles Mar 04 Dec 14 designed for individual investors have remained open. Source: MFS. Data Mar 2004 to Dec 2014.

Exhibit 6: Global equity capacity management decisions Exhibit B: Market cap (USD) – MFS Global Equity Apr 2006 Dec 2011 Oct 2013 Soft close — Closed institutional Contributions from Weighted average market cap – MFS vs. MSCI World No new separate pooled funds current separate account 120% accounts to new accounts clients no longer accepted 100% 2006 2011 2013 80% 60%

40% The rationale for closing Global Equity was that it would slow the growth of Mar 04 Dec 14 assets for the following reasons: Source: MFS. Data Mar 2004 to Dec 2014. • Protect the interests of existing and future clients by preserving investment flexibility for portfolio managers such that they are able to potentially deliver Exhibit C: Number of holdings – MFS Global Equity performance in line with client expectations 110 • Preserve capacity for other existing strategies as well as the prudent launch of new investment strategies driven by client demand 100 • Minimize the non-investment responsibilities of the portfolio managers 90 by limiting large mandates that usually require significant marketing and

service requirements to allow the existing client portfolios to receive the 80 requisite focus Mar 04 Dec 14 Source: MFS. Data Mar 2004 to Dec 2014. Portfolio characteristics The portfolio managers have been able to continue to pursue active alpha- Exhibit D: Annual turnover – MFS Global Equity generating investment opportunities in line with the investment philosophy and process for the strategy. A sample of Global Equity portfolio characteristics are Name turnover Portfolio turnover shown in Exhibits A – D. 50% 40%

30%

20%

10% 0% Dec 04 Dec 14 Source: MFS. Data Dec 2004 to Dec 2014.

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Fixed-income capacity management MFS has imposed restrictions on strategies other than As we mentioned in the introduction, this paper is largely Global Equity in keeping with the approach outlined in this focused on outlining our approach to managing capacity in paper. Currently, the list of strategies subject to a restriction equity portfolios. Our capacity methodology in the case of of some kind includes European Research, European Smaller fixed income is similar in certain respects to equities; however, Companies, European Value, Global Concentrated, Global there are also some key differences. The overall architecture Value, International Small Cap, International Value and US of the capacity review is comparable in that they both Large Cap Value, in addition to Global Equity. This list is an comprise three key elements: quantitative model, qualitative indication of the commitment MFS has made to a rigorous assessment and non-portfolio considerations. The nature of capacity risk review process and, in doing so, protecting the securities and the markets means that the fixed-income clients’ interests. quantitative model differs in the following regards: Conclusion • Trading volume is not considered in the fixed-income MFS employs both quantitative analysis and qualitative model. assessments to help measure and manage capacity. Given • Replication constraints are placed at both the bond issue how important capacity management is to the overall and the issuer level. investment process, we consider capacity under the rubric • Only non-government issues are considered in the of risk and review capacity within the context of the semi­ replication process. annual risk review process. Idea generation, business diversification and portfolio manager non-investment Product closure decisions responsibilities are additional considerations taken into Based on the various factors described above, product account in capacity decisions. closures are implemented at appropriate asset levels to The firm has taken steps to close a number of products in line protect the interests of our clients. The interests of existing with the capacity management approach outlined in this and future clients are protected by preserving investment paper. This includes the soft close imposed on Global Equity flexibility for our portfolio managers. The MFS goal is to put in 2006, which has been followed by additional restrictions each portfolio manager in the best potential position to on asset inflows into the strategy. generate superior risk-adjusted performance for our clients. In general, we are committed to managing capacity to The firm has tended to adopt a staged approach to preserve alpha-generating capability for clients. We believe managing capacity in the past, with soft close decisions that we can build trust and credibility with clients by working preceding hard closure of the strategy, in part to minimize in their interests, and simultaneously create a business model business disruptions for clients invested in the strategy. that is sustainable in the long term. This is illustrated in the timeline provided for the capacity management decisions made with regard to the Global Equity strategy (see page 7: Global Equity Case Study). When circumstances change, we have also made the decision to reopen strategies or roll back the soft close. A differentiated approach is often adopted for the retail versus institutional markets to account for the fact that it is much easier to accommodate inflows of smaller amounts of retail assets than it is to absorb larger pools of funds in institutional separate accounts. Also, it is worth noting that a proportion of institutional account redemptions take place on a regular basis for reasons outside the control of the investment manager concerned. In this context, the inflow of retail assets can be seen as replacing some of these institutional outflows.

8 The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. (‘MFSI’) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited (‘MIL UK’), a registered in England and Wales with the company number 03062718, and authorised and regulated in the conduct of investment business by the UK Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered offi ce at One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. Issued in Hong Kong by MFS International (Hong Kong) Limited (‘MIL HK’), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the ‘SFC’). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a US-based investment advisor and fund sponsor registered with the US Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to ‘professional investors’ as defi ned in the Securities and Futures Ordinance (‘SFO’). Issued in Singapore by MFS International Singapore Pte. Ltd., a private limited company registered in Singapore with the company number 201228809M, and further licensed and regulated by the Monetary Authority of Singapore. Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian fi nancial services license under the Act 2001 in respect of the fi nancial services they provide. In Australia and New Zealand: MFSI is regulated by the US Securities and Exchange Commission under US laws, and MIL UK is regulated by the UK Financial Conduct Authority under UK laws, which differ from Australian and New Zealand laws.

MFSI-CAPACMB-WP-4/15 30201.2