By Haim Mozes and Jason Orchard, Spring Mountain Capital -- It is commonly believed that large hedge funds are safer than smaller hedge funds. Consequently, the overwhelming majority of new capital currently being allocated to hedge funds has gone to the very largest funds. However, Spring Mountain Capital’s (SMC) research disputes this long held belief and demonstrates that certain measures of risk are greater for larger funds. Additionally, our research shows that as hedge funds grow in size, their return profile becomes less appealing to investors.
One of the reasons SMC decided to undertake this research was that our intuition and experience in managing various hedge-fund strategies, both as direct investors, and as investors in hedge funds led us to believe that smaller funds outperformed larger funds on average. Secondly, we had observed a very strong trend in the industry. Recently, new capital or capital returning to the hedge fund industry after the 2007-2008 financial crisis was primarily being invested in the very large funds. We believe this was because hedge fund investors perceive larger funds as safer investment opportunities relative to their smaller peers. We hoped our research would help quantify and validate our intuition about size and performance as well as allow us to measure how much safer large funds actually were.
The research suggests that, on average, larger funds typically underperform their smaller peers and that the quality of those returns is also weaker. Quantifying the impact of fund size on performance, we find that hedge funds above the 95th percentile of assets under management (today that level is approximately $1.5B) have average alphas that are 20 basis points per month lower than other funds, and have average betas that are 0.15 higher than other funds. While 20 basis points per month may not seem like a significant difference, the average monthly hedge fund alpha (unweighted) is in the range of 40 basis points. Likewise, while a difference of 0.15 in beta exposure may not seem significant, the average hedge fund beta (unweighted) is in the range of 0.30
Examining risk, we find that large hedge funds are more likely to close or restrict investor redemptions within three years than are smaller funds. This discovery is in stark contrast with the current perception of the marketplace. However, recent history should be a sobering reminder for many hedge fund investors. During the financial crisis of 2007-2008, it was larger funds that typically gated investors or restricted liquidity in contrast to their smaller peers, which became liquidity providers for hedge fund investors despite stronger relative performance.
Considering closure risk is an important factor, the SMC research suggests returns of funds that close dramatically decline in the 12 months prior to closing. In addition, there is an opportunity cost in the period between the funds’ closing and when investors’ capital is returned, and that period is likely to generate additional losses to those incurred prior to closing.
Another important finding from the SMC research is that fund-raising can be a meaningful contributor to performance. For example, consider funds that grow large presumably by starting with strong performance as a smaller manager. Because they have good performance, it could lead to significant fund-raising success. The fund may generate positive returns due to putting its new capital to work. This raises the prices of acquired assets above the average purchase price for those assets. Those strong returns may lead to further capital raising, which may lead to additional returns being generated. Eventually, however, the cycle ends as capital inflows slow and new investments are not large enough to generate performance by themselves, returns become moderate, and investors recognize that the fund has capacity issues. Thus, it may take time before performance and risk weaken for larger funds and it is this sequence that is consistent with our findings for large funds that close - the decline in fund-raising typically precedes the decline in performance. The opposite holds true for small funds that close. For small funds, the decline in fund-raising follows the decline in performance.
It is important to note, that we are not saying all large hedge funds are bad. On the contrary, the SMC research suggests that it is very difficult for a fund to be large, liquid, and good. We believe this is simply due to the fact that there is not enough liquid alpha for large hedge funds to generate a return profile that investors require.
In addition, when the inevitable investment bump occurs investors often get spooked and exercise their redemption rights. The process of selling assets to generate liquidity may generate significant losses because of the large position sizes involved, and these losses may themselves trigger further redemptions.
However, there is an answer to how hedge funds can solve this problem. If large hedge funds adopt a private-equity like approach to investor redemption rights, they can potentially generate returns that have a higher alpha and lower beta component because they will not need to focus on more liquid investments.
In conclusion, our research suggests that there is a very real opportunity cost of investing in large funds relative to smaller funds. Additionally, the perceived safety benefit of larger funds is, at the very least, not as strong as generally believed and by some measures of risk significantly more risky than smaller funds. We also observed that declining momentum in fund-raising is typically a strong leading indicator of deteriorating performance. Finally, in order to grow and survive, large hedge funds will need to consider a transition to a private-equity type model where capital is locked-up for long periods of time, or to an investment-bank model, where the capital is permanent and it is relatively easy to access public markets for capital to maintain an appropriate risk and return profile for its investors.
The article is based on a recently released white paper, which was co-authored by Haim Mozes, Ph.D, a Senior Consultant at Spring Mountain Capital and Jason Orchard, a Principal at Spring Mountain Capital. Mozes is also an Associate Professor of Accounting at Fordham University in New York. You can download the full white paper, The Relation Between Hedge Fund Size and Risk, at Spring Mountain Capital.