Bigger hedge funds didn’t do as well as smaller ones over a recent 20-year stretch, and that disparity was even more pronounced during the 2008-09 financial crisis.
So concludes a working paper by three finance professors at City University London. Among investors, however, “the demand has been for larger funds,” says Nick Motson, one of the paper’s authors.
As of Oct. 31, an estimated 90% of the nearly $3 trillion of global hedge fund assets was in the hands of firms that manage more than $1 billion, according to HFR, a Chicago firm that tracks the industry. In contrast, firms overseeing less than $100 million accounted for under 5% of total assets. And roughly two-thirds of hedge fund assets are managed by the top 6% of all hedge-fund firms.
Motson and two colleagues, Andrew Clare and Dirk Nitzsche, crunched hedge fund returns stretching from January 1995 to December 2014. In all, they analyzed 7,261 funds, including those that had closed over that span, to avoid survivorship bias.
They found that the largest funds—those in the top decile based on assets under management—returned 0.61% per month, on average. That’s below the monthly return of 0.75% for the funds in the bottom decile for assets.
On a yearly basis, the behemoths averaged a 7.32% return, versus 9% for the smallest portfolios.
That’s a pretty sizable gap, particularly since the larger funds typically market themselves as offering better infrastructure, including risk management, technology, and compliance capabilities, than do smaller funds. And they usually have more cachet, with recognizable-name partners.
One possible explanation for the performance disparity, says Motson, is that the bigger a fund gets, the more closely it correlates with the overall market. “And there’s only so much money you can put into your best ideas,” he notes.
Of course, the object of many hedge fund strategies is to zig when the stock market zags, in order to offer ballast to a portfolio. The numbers, also, are merely averages. There are plenty of large hedge fund shops that have put up strong numbers over time, among them Ken Griffin’s Citadel and David Tepper’s Appaloosa Management
Scott Schweighauser, president of Aurora Investment Management, a nearly $8 billion fund of hedge funds, says that the paper’s findings make sense, though he’s agnostic when it comes to investing in a hedge fund based on size.
It’s important to understand the fee structure of hedge funds, which mainly generate revenue from two sources: a management fee, often 2% of assets under management, and an incentive fee, typically a 20% cut of the fund’s profits. Smaller funds, Schweighauser says, are “much more attuned to generating returns that capture that incentive fee” because of their size. But, “as firms grow, the management fee becomes a much larger [part] of the overall revenue stream.” Indeed, 2% of $20 million is a lot less than 2% of $3 billion.
Schweighauser argues that a bigger firm with a more cautious, less volatile approach can work well, provided that it is what investors want.
MANAGING A LOT MORE assets, however, can change a hedge fund firm’s DNA, says Peter Borish, chief strategist at Quad Group, which helps smaller hedge funds with back-office functions, funding, and other support. He likens many of the large funds to a “supertanker” that isn’t “nimble.”
There’s also a tendency for larger funds to be more risk averse, says Borish, who worked for Tudor Investment for a decade with the firm’s founder, Paul Tudor Jones. “If I take a risk and I’m wrong, I may lose assets,” he says of the mind-set of some bigger funds.