The Capacity of Trading Strategies.

Summary Due to non-linear transaction costs, the financial performance of a trading strategy decreases with portfolio size. Using a dynamic trading model a la Garleanu and Pedersen (2013), we derive closed-form formulas for the performance-to-scale frontier reached by competitive traders endowed with a signal predicting stock returns. The decay with scale of the realized Sharpe ratio is slower for strategies that (1) trade more liquid stocks (2) are based on signals that do not fade away quickly and (3) have strong frictionless performance. We apply the framework to four well-known strategies. The capacity of strategies has increased in the 2000s compared to the 1990s due to increased liquidity. Because low volatility and past accounting profitability are persistent characteristics, strategies based on them are highly scalable, including in the mid-cap range. When traders underestimate the number of competitors trading a similar signal, their performance is strongly negatively impacted.