The top list of Institutional Investor’s hedge fund list reveals a truism about institutional investors without saying it out loud.

Hedge Fund

Favor given to largest hedge funds

Hedge fund assets grew in 2013 by 9.7 percent, to $2.85 trillion, according hedge fund data provider eVestment, while the top 100 funds, the upper percent, account for more than half of total industry assets, and their share has been increasing, an article in Institutional Investor noted.

The issue is the asset disparity between the top 2% of hedge funds and the balance of the hedge fund community — call this “asset inequality” — continues to grow wider.

Jumping through meaningless hoops and investing in IBM

Institutional investors are generally known to favor the largest, most established names.  Invest with those in the “club” with other members and “you can’t go wrong selecting International Business Machines Corp. (NYSE:IBM).” As professionals inside the fund world will sometimes (or all the time) say that the selection process is about jumping through hoops and very little understanding of how a strategy correlates with other strategies in market environments – the issues that should matter most – go without much attention.

The truth is selection of alternative investment funds is more of an art than a science – and this needs to change, say some in the algorithmic trading community.  The cold hard facts in a number of studies point to a statistical bias towards mid-sized funds.  Depending on the study one looks at, the sweet spot is a little over $200 million to $500 million in assets.  Big enough to support business operations but not so big as to have their strategy limited in smaller markets that require nimble reflexes.

Against this backdrop comes the Institutional Investor article by Stephen Taub, highlighting how the larger hedge funds receive the lion’s share of assets – again and again.  While studies have come out on both sides of the big vs small issue, the abnormal shape of the asset distribution bell curve is nothing short of absurd.  Any total focus of allocation towards an extreme mean is typically not advised in portfolio construction, however that’s exactly what is happening in hedge fund allocations.

Some funds that have strangely delivered the illusive alpha in a variety of market environments

“Most of the new money that the big funds are getting is from public pension plans,” Maneck Kotwal, an investment officer at the New Jersey Division of Investment, was quoted as saying. Interesting to note is the changing profile of the institutional investor, moving more to pension funds than from its traditional base of more flexible foundations and high-net-worth individuals. “Because of their size and being in the public eye, pension funds gravitate to the larger firms,” he says. “It’s the same reason they used to buy IBM.”

Hedge Fund: “All weather” funds that adjust in market environment winners

Of the major firms that racked in assets in 2013 was a hedge fund that has a variable solution relative to market environment.  For the fourth year, the article notes, Ray Dalio is the leading hedge fund manager with $87 billion under management.  Dalio’s fund, Bridgewater, operates different strategies that are said to be selected for a portfolio based on strategy correlation and market environment.  He is the most visible embodiment of the “all weather” portfolio and is said to employ many quantitative  tools of probability analysis.  The fund’s inclusion in the major managed futures indices has been a bone of some contention as well, with certain indices not including him because of his lack to sole focus in managed futures.  Without Bridgewater, the managed futures assets under management picture is very different indeed.

Again for the fourth year in a row, JPMorgan Asset Management, which owns Highbridge Capital Management, took the second with $59 billion in assets managed.  Brevan Howard is third with $40 billion and the family-run Och-Ziff Capital Management Group is in fourth place at $36.1 billion.

Momentum trader AQR Capital has a different approach than Winton

Other notables on the top list of those managing significant money includes AQR Capital Management, operated by the quantitative mind of Cliff Asness who is better at math than he is at keeping his politically incorrect comments to himself.  Asness, known as a trend follower, is generally in the same camp with Winton Capital Management and Bridgewater in that they all use algorithmic trading methods to drive decisions.  However, Winton’s David Harding has significantly enhanced his algorithms to incorporate a variety of market environments, breaking away from his “moving average” cross trend following origins. Perhaps it is the strategy diversification, into carry and relative value trades, that Winton doesn’t need strong market trends that he claims that US Federal Reserve artificial control of market prices doesn’t matter to managed futures performance.

Is Ackman a “buy on a drawdown” candidate?

Bill Ackman’s Pershing Square Capital Management is mentioned in the article, as his Allergan, Inc. (NYSE:AGN) / Valeant Pharmaceuticals Intl Inc (NYSE:VRX) (TSE:VRX) deal could go down in history as one of the most creatively conceived and most successful trades in history.  As the bidding war for Allergan begins, Ackman now wants to encourage a fight and get out at the top.  Pure genius.  The big question will Ackman’s use of the regulatory card and sharp elbowed activist investing strategies endure?  Some in the alternative investing universe say that Ackman is a hedge fund to invest on a drawdown.  All eyes on Ackman not as he exits the Allergan deal – that will look like a symphony conducted by the maestro.  The issue will be can his brand of aggressive activism endure?