How do capacity constraints influence portfolio construction at large hedge funds?

How to answer

Capacity constraints limit how much capital a strategy can deploy before returns degrade due to market impact and crowding. A $500M small-cap strategy might have capacity of $2B before trade execution costs erode alpha. Large funds like Citadel ($60B+) face capacity challenges: more AUM means more market impact, harder to exit positions in stress, and fewer alpha opportunities per dollar. This drives construction toward: more positions with smaller individual sizes, higher-liquidity names, multiple uncorrelated strategies, and sophisticated execution algorithms. Funds that exceed capacity often see Sharpe degradation of 0.2-0.5 points.

Key idea: More AUM means more impact cost — scale kills alpha if not managed.