Rising hedge fund managers can quickly become victims of their own success. Outperformance brings inflows to the fund, bloating it until the high returns that first brought new investors starts to suffer, driving them away again. For a hedge fund investor who wants to stick with a proven manager but is concerned with rising AUM, this poses a dilemma with no easy solution.

“The key is looking beyond returns. By the time returns deteriorate, it’s too late to act,” writes Novus Head of Europe Andrea Gentilini. “By then, the negative impact of AUM on performance has already materialized, and allocators have foregone the opportunity to invest their money elsewhere.”

While there isn’t a complete consensus that rising AUM hurts hedge fund returns, Gentilini thinks the connection is strong enough that it can be an ‘informational edge’ for investors to use. But first, the transmission mechanism needs to be identified so that investors know which leading indicators to keep an eye on.

Gentilini proposes three mechanisms for high AUM to impact returns from long/short equity investments: a growing number of positions, rising median market cap, and falling liquidity.

Looking for the impact of rising AUM

The first proposal makes the most intuitive sense and is the one that most people assume is behind falling returns. If a hedge fund manager is already putting his 25 best ideas to work, then expanding to 50 ideas means expanding down. In other words, he doesn’t have another 25 best ideas, only the 25 next best. A given hedge fund manager might not have expended all their market-beating ideas, or might be able to scale up with new recruits and strong business practices, but many will start putting money to work on sub-par investments.

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Rising AUM also forces a fund to focus on bigger companies, because small caps just can’t impact returns enough to justify the research and overhead behind every trade. Focusing on bigger companies, which tend to have better media and analyst exposure, can make it more challenging to find price dislocations and push managers out of the arenas in which they first made their name.

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“If AUM grows and neither of the above happens, liquidity inevitably deteriorates,” writes Gentilini, explaining that liquidity is the one factor that’s not entirely under a manager’s control. “We think that this metric should be the most closely monitored of the three. In reality, we find that it’s the least observed.”

Falling liquidity adds risk to a hedge fund’s portfolio because of the potential for asset-liability mismatch, but it also makes it harder for a fund to make tactical trades without incurring significant trading costs. Gentilini’s own research shows that higher AUM doesn’t correlate to reduced liquidity, but that doesn’t mean it shouldn’t be a concern.

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Moving past purely returns-based manager selection

While all three of these trends might explain the connection between rising AUM and poor returns, Gentilini’s research can’t prove that transmission is happening because his data is static. In other words, even if higher AUM correlates to a portfolio with a higher median market cap, that doesn’t mean that increasing the first will cause an increase in the second at a given hedge fund. Restricting himself to long/short funds managed by Tiger Cubs also means that the results might not generalize very well.

Even so, with so much more money being allocated to hedge funds (and to funds of hedge funds), moving beyond a qualitative or a purely returns-based manager selection process will be a huge advantage for whoever can figure out the best way forward.