Big Doesn’t Mean Better for HFs, Study Finds

Big isn’t necessarily beautiful when it comes to hedge funds, especially during times of crises, according to research.

In a study of hedge fund size and performance between 1994 and 2014, City University London’s Andrew Clare, Dirk Nitzsche, and Nick Motson found investors were better off at the smaller end of the scale.

“Smaller funds outperformed their larger counterparts for all but three of the 20 years 1994-2014.” —City University London.According to the study, the largest decile of funds returned an average of 0.61% per month, with a standard deviation of 0.66% and a Sharpe ratio of 0.62. The smallest decile, however, generated an average return of 0.74%, a standard deviation of 0.72% and a Sharpe ratio of 0.74.

Smaller funds outperformed their larger counterparts for all but three of the 20 years covered by the study, the paper found, with correlations intensifying for periods following the collapse of the tech bubble and the global financial crisis.

This phenomenon could be explained by the compositions of the varying hedge funds, the authors wrote.

Bigger funds generally include “more potentially flighty fund of fund investments” that could have distracted managers from focusing on investment strategies during times of major outflows, according to Clare, Nitzsche, and Motson. 

Smaller hedge funds could have also had arrangements that limited the impact of redemption had on performance during times of crises.

Furthermore, it could be that smaller hedge funds have less beta, or market risk, within their portfolios, the authors said.

Additionally, hedge fund managers do not age well, the study claimed—at least in terms of performance.

“One would hope that a hedge fund’s performance would—like a vintage wine—improve with fund age, as the fund’s managers become more experience at managing their funds and strategies,” the paper said.

Despite these expectations, data revealed that older funds produced lower returns compared with their less-established counterparts. And the relationship was particularly negative during 1996 to 2002. 

These correlations among fund size, age, and performance varied by strategy, according to the paper.

Long/short equities, emerging markets, and event driven strategies all demonstrated that smaller and younger was better over the past twenty years, with spikes during and after the tech bubble, the 2008 crisis, and the South East Asian financial crisis.

Bucking the trend were managed futures, which, by benefiting from lesser constraints in assets under management, saw some bigger funds outperforming smaller funds from 1998 to 2003.

However, the authors also found the benefits of larger funds in this trend-bucking category were marginal and the phenomenon dissipated 10 years ago.

Read the full paper “Are Investors Better Off with Small Hedge Funds in Times of Crisis?”.

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