It is often claimed that smaller hedge funds outperform their larger rivals and that funds perform best in their early years, but is this truly the case?
A large body of research in hedge fund databases shows that start-up funds outperform established funds in the first 18 months or so of their existence. Many industry experts also argue that smaller funds tend to be more aggressive than their rivals and thus produce higher returns, though there is less verifiable evidence to support this claim.
Database Bias
The problem is that most of these assertions are based on hedge fund databases and these do not provide a perfect insight into the industry.
For Example:
• Start-up hedge funds that do not perform do not earn performance fees and are thus more likely to fail, which means that underperforming start-ups drop out of the database;
• Following on from that, as reporting to the databases is voluntary, only hedge funds that can benefit (i.e. have the track record and need to raise assets) are going to sign up for an index — poor performers need not apply (this is known as reporting bias);
• Those funds that do decide to report to a database may use favorable early returns to “backfill” their historical performance. In their 2003 paper “A Reality Check on Hedge Fund Returns”, Nolke Posthumay and Pieter Jelle van der Sluisz calculate that backfill bias may skew returns by a magnitude of as much as 4 percent.
• Additionally, hedge funds remain in the database because they want to attract fresh investment, so top performers will retire from the index when they close for fresh investment.
While many of these database flaws are excluded from the published indices that are based on them, they are often reflected in studies of the raw material that underpins those indices.
Scale
That goes some way to explaining difference in the performance figures for early and late stage hedge funds. Scale, however, is a separate issue. The databases do not provide a great deal of insight into the size of hedge funds as they tend to record returns over time. Most of the arguments for scale, therefore, are quantitative.
It has been argued that hedge funds have a critical mass beyond which they become less efficient. This is because trades, particularly on leveraged products, become so large that they are hard to implement and that assets are, by necessity, diffused over a wider number of instruments. Larger funds are also thought to be more conservative, as they are usually not seeking additional assets so the managers are intuitively more risk averse. On the other hand, managers with fewer assets are, in theory, eager to impress potential investors and therefore more focused on total returns.
Variations by Style
These scale arguments tend to carry more weight in less liquid markets and are largely dependent on trading methodologies.
Managed futures funds, for example, trade in a very wide range of highly liquid markets and often use technology based trading systems to identify and act upon opportunities. As a result, scale is unlikely to make much difference as the opportunity set is enormous and a higher volume of trades does not require additional resources.
On the other hand, strategies that trade in illiquid markets or are highly reliant on the participation of the manager, such as leveraged finance, may well benefit from being smaller.
Big Can Be an Advantage
There are also disadvantages to small or new funds. The vast majority of funds that fail do so in their first few years of operation, and many failed funds do so for operational reasons. One reason for this is because, due to their small scale, they are unable to generate sufficient fee income to support their operational needs.
Bigger funds, by comparison, generate the revenues needed to survive and are frequently in a position to differentiate themselves through improved customer service. Older funds are also arguably wiser, having negotiated and resolved potential operational issues and developed the procedures and systems necessary to guarantee the continuation of their business — even after prime personnel, such as a founding partner, leave the business.
Conclusion
This does not mean that bigger or more developed funds are a better investment than smaller funds. Nor does the evidence support the opposite argument. In the final analysis, scale and state of development do not constitute suitably criteria for selecting a hedge fund. Investors should instead focus on the manager’s experience, operational capabilities, risk management structure, and strategy. Scale will be influential in some styles, and years of operation do provide measurable performance criteria on which an investment can be based, but in the final analysis investors should focus on a manager’s ability to deliver the returns they promise with the required level of volatility over the medium to long term.
(Antoine Massad is head of Middle East and Asia at Man Investments in Dubai.)
