You’ve probably heard the conventional wisdom: Smaller, younger hedge funds are more nimble, and tend to bring better returns than their bulky, aging cousins.
But youth and size are not the same thing. About 85 percent of young funds—under 2 years old—manage less than $250 million in assets, but only about 14 percent of all small funds are young. That’s down from 42 percent of all small funds about a decade ago.
That may sound like simple semantics, but it matters because “young” funds and “small” funds don’t behave the same when it comes to returns. While young funds do, in fact, tend to outperform older funds, small funds haven’t been doing as well in recent years.
Looking at Sharpe ratios, a measure of risk-adjusted return, small hedge funds have been underperforming medium-sized funds for the last six years, a stark difference from strong returns before the financial downturn, according to an analysis of thousands of reporting funds by eVestment Alternatives Research (click on image):
“Everyone thinks that small funds perform well, but we see that disappearing over time,” said Peter Laurelli, vice president of research at eVestment.
What changed? Both the market environment and the strategy composition of the different categories shifted over that time, said Laurelli. Most of the early outperformance from the smaller funds came from emerging market strategies, where smaller funds were more likely to be focused on specific countries and to operate in more volatile environments. Later, small funds also outperformed in managed futures and macro strategies, he said.
“The post-financial crisis environment has seen each of these groups go through periods of difficulty, driven by their respective market environments,” said Laurelli.
Investors seem to be catching on. The proportion of small hedge funds has been falling, and investors seem to be favoring medium and large funds. New funds also tend to be larger, with the percentage of young funds that are medium-sized growing from less than 8 percent before the financial crisis to about 13 percent in 2013.
As for young hedge funds, they tend to have healthy returns because by definition they have a timing advantage—funds tend to be formed at times that are advantageous for their specific strategies. For example, a crop of successful securitized credit strategy funds was founded after the recession in response to opportunities in that area, and while all types of funds saw good returns for that type of strategy at that time, those returns will raise the “young fund” category because they were created at that time.
The biggest funds are big for a reason
The 30 largest, most prominent hedge funds at the end of 2014 performed better than any group aside from the average young fund. Last year, those funds returned a little more than 6 percent—missing the young funds by just 5 basis points.
The biggest funds together manage nearly $450 billion, yet was one of the only groups—again, along with young funds—to end in the black in 2011. Even in 2008, the largest funds limited their losses to an average of 0.65 percent, despite the added difficulty of moving their much larger investments.
About 10 of those 30 largest funds use macro or managed futures strategies, that led to healthy returns around the time of the financial crisis. Eight used credit strategies, which were strong after the crisis. Others were multistrategy or distressed and special situation investing, said Laurelli. Few are pure equity products, so the losses of 2008 and 2011 harmed the largest group the least.
And of course, big funds don’t usually get big by being bad at what they do.“Prominent funds become prominent because their performance warrants growth of assets,” said Laurelli. “Performance is a mix of opportunity, the ability to attract and pay the talent to exploit opportunity, and the scale needed to profitably exploit opportunities.”
Return isn’t everything
While some small funds have struggled to raise capital and gone bust, some have had solid returns and will continue to attract interest, said Amy Bensted, head of hedge fund products at Preqin, an alternative assets intelligence firm.
Preqin classifies funds with $100 million or less in assets as small, but the company sees similar results to eVestment, said Bensted. Preqin hasn’t looked specifically at the top 30, but the firm generally finds that it’s the middle range—funds with $100 million to $500 million in assets—that perform the best in returns.
But there is more to hedge fund investing than simply looking at average returns or risk-adjusted returns, she said.
“It’s not just about returns and long-term gains, it’s more about the types of investors who may be interested in these funds,” said Bensted, “Maybe they’re looking for a true hedge fund with a unique strategy, or they might have lower fees.”It’s difficult to categorize funds or judge them on one metric alone. Size and age are just two of many ways to break apart the market.
“Every one is unique, and size is part of that uniqueness,” said Bensted. “It’s an interesting way to look at it, and a good way to frame the market.”
Stephen Weiss, managing partner for Short Hills Capital Partners and a CNBC contributor, said that his “fund of funds” strongly prefers smaller funds that are one or two years old and run by managers with a “strong pedigree.”
“However, it takes a lot more work to find these funds,” said Weiss. “Larger funds have more assets because endowments and pensions—institutional investors—have a bogie of 5 to 8 percent return and a self-imposed mandate to not lose their jobs by recommending a non-brand name fund.”
Smaller, younger managers are more driven by returns because they haven’t made their fortunes yet, said Weiss. Categorical returns are averages, so if an investor can pick the right small funds, they can still pay off.
The article above delves deeply into a topic that I’ve covered over the years. My own thinking has evolved on the subject as I’m ever more convinced this is a brutal environment for all hedge funds and only the strongest will survive.
This is why I keep warning Soros wannabes to really rethink their plan to start a hedge fund, unless of course they are his protégé, in which case the chances of success are infinitely higher.
What has changed? First and foremost, the institutionalization of hedge funds has fundamentally altered the landscape and there are reasons why the biggest hedge funds keep growing bigger:
- The biggest hedge funds are typically trading in highly scalable, liquid strategies and are a better fit for large global pension and sovereign wealth funds that prefer allocating to a few large “brand name” hedge funds than to many small hedge funds. It’s not just about reputation or career risk, it’s also about allocating human resources to perform due diligence on all these smaller funds and monitor them carefully.
- The biggest hedge funds have the resources to hire the very best investment, back office and middle office personnel. Not only do they attract top talent away from banks and smaller hedge funds but also from large, rival large hedge funds. More importantly, they’re able to hire top compliance and risk officers, which helps them pass the due diligence from large institutions.
Having said this, there are pros and cons to investing with the ‘biggest and the best,” especially in Hedgeland where useless consultants typically recommend the hottest hedge funds to their clueless clients, even though these are the funds they should be avoiding at all cost.
- The big hedge funds attract billions in assets and collect 1.5% to 2% in management fee no matter how well or how poorly they perform. This incentivizes them to focus more on asset gathering and less on performance. Collecting a 2% management fee is fine when you’re starting off a hedge fund; not so much when you pass the $10 billion mark in AUM (and some think even less than that).
- Large hedge funds are typically led by larger-than-life personalities who don’t give even their large investors the time of day. You’re never going to get to meet Ray Dalio, Ken Griffin, or many other big hedge fund hot shots when conducting your on-site visits (I was lucky to meet Ray Dalio because I was accompanied by the president of PSP at the time and insisted on it).
- This means you won’t gain the same rapport and knowledge leverage that you can gain by investing in a smaller manager who is more open to cultivating a deeper relationship with a long term investor.
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