A Preqin study confirms what certain professional investors have long advocated: best results can be found in managers nimble enough to enter lightly traded markets and get in and out quickly and efficiently.  For aggressive investors, this often meant a portfolio focus on funds with under $1 billion in assets but selecting funds large enough to the point the business could sustain itself.

Investors Fund Size

Does fund size matter to investors? Of course it does

In an article titled “Does Fund Size Affect Hedge Fund Performance?” author Selina Sy noted the most significant average returns were in the fund category from $100 million in assets under management to $1 billion.  Funds with less than $100 million in management delivered the lowest returns, as measured in the study.  Funds under $100 million are sometimes considered more speculative by investors because their business operations might be a distraction, while funds over $100 million can typically cover appropriate operational, risk management and research costs.

The report noted that while investors look at a variety of factors when evaluating potential investments, performance remains on top of the review list.  48% of investors said returns are a key factor when looking at a fund manager and 21% of investors also stated the potential for better returns from smaller managers as a reason for preferring funds with less than $1 billion in assets under management, the report noted. Many investors lack the skill and risk appetite to make meaningful allocations to smaller funds and instead look to invest in more established funds. However, the report noted that opportunities for smaller funds with assets under management below $100 million could grow as sophisticated investors look for niche opportunities.  However, the issue of volatility remains a key concern.

Volatility of returns at issue

While gross returns is always the headline, sophisticated investors note that volatility – or more specifically consistency of volatility – is an issue.  The study noted 28% of hedge fund investors cited consistency or low volatility of returns as their top returns objective from their hedge fund investments, while 25% named high risk-adjusted returns as the key factor.

The volatility discussion tends to favor larger hedge funds, many of whom have found the sweet spot formula of consistent returns with dampened value swings – and have raised significant assets as a result.  “Larger top performing funds have clearly demonstrated a tendency towards lower risk, albeit with lower returns, over the three-year period, which has no doubt satisfied the more risk-averse investors that are looking towards established track records with minimum volatility,” the report observed.

In regards to volatility, smaller funds appear to have the highest degree of value disparity. “Top performing funds with assets of less than $100mn have shown the largest variation in risk-return profile over the three-year period, with these funds exhibiting higher returns and higher volatility than their larger counterparts,” the report said, noting this indicates that while smaller funds have potential to deliver attractive returns, investing in this area requires a high degree of investor skill due to volatility.

Where is the best volatility return mix?

Prequin Distribution of returns fund size

The report notes that as funds become larger, the distribution of returns and relative volatility trend towards a tighter range. “The size range $500-999 million had the lowest proportion of funds suffering a loss in 2013, and the longer term return and volatility characteristics of these funds are similar to funds with assets of more than $1 billion,” the report concluded. “Therefore, those investors which are looking to move away from investing in just largest funds, but without taking on too much volatility, may choose to look towards investing in those funds with more than $500 million in assets.”