Are Investors Better Off With Small Hedge Funds In Times Of Crisis?
The time-varying nature of the relationship between hedge fund performance and size
Andrew Clare, Dirk Nitzsche and Nick Motson
Centre for Asset Management Research,
The Sir John Cass Business School, City University, London, UK.
With the benefit of a more comprehensive dataset than previous authors in this area, in this paper we revisit the relationship between hedge fund performance and size. Our results indicate that there is a strong, negative relationship between hedge fund performance and size. But, in addition, we also find that rather than dissipating during the two recent periods of financial crisis, other things equal, investors would have been better off with smaller hedge funds than with large ones during these crisis periods. Finally, we also document clear cross-sectional variation in this relationship by broad hedge fund strategy.
Are Investors Better Off With Small Hedge Funds In Times Of Crisis? – Introduction
Over the last ten to fifteen years the fund management industry has become increasingly bifurcated. On the one hand so called passive funds, by which people generally invest in index funds where component weights are determined by their market capitalisations, continue to attract huge inflows. For example, in the US where the idea of ‘passive’ investing began, according to the 2014 Investment Company Fact Book2 (ICFB), the share of assets invested in index equity mutual funds relative to all equity mutual fund assets was 18.4% at the end of 2013, up from 9.5% in 2000, and between 2007 and 2013 passive US equity mutual funds (and ETFs) experienced cumulated net inflows of $795bn while equivalent actively managed investment vehicles experienced a net outflow of $575bn over the same period. Similar trends are well established both outside the US market and amongst institutional investors too, to such an extent that the world’s three largest asset managers by global AUM – Blackrock, Vanguard Asset Management and State Street Global Advisers – all have substantial passive businesses.
The antithesis of the sort of passive investment techniques that have helped some asset management firms gather in billions and billions of assets, garnering increasing economies of scale as they do so, is the active fund management industry. As millions of both retail and institutional investors have moved money into passive investment vehicles, the active fund management industry’s performance and fees has come under increasing scrutiny. The debate about ‘active share’, following Cremers and Petajisto (2009), brought into even sharper focus the idea that active fund managers should be truly active rather than simply being ‘benchmark huggers’ that charge active fees for essentially passive performance. For active mutual fund managers, capacity issues are a more pressing concern, particularly if the fund focuses on niche parts of any market. Because of this managers will specify, though normally only when prompted, a maximum AUM for their fund and strategy. A number of academic studies have investigated the relationship between mutual fund performance and fund size. Berk and Green (2004) found that although more highly-skilled managers tended to manage more assets, diseconomies of scale meant that the expected returns on their funds were no different than those managed by less skilled managers. Other authors, including Chen et al (2004) also find a negative relationship between the size of a mutual fund and its subsequent performance. However, in a more recent paper Reuter and Zitzewitz (2013) find “little evidence of net diseconomies of scale” amongst long only US mutual funds.
Capacity constraints may then be an issue for active mutual fund managers, but it seems likely that any constraints and associated diseconomies of scale are more likely to be found in the hedge fund industry where managers: employ (in many cases) highly focused investment strategies; make extensive use of leverage; invest in illiquid asset classes; concentrate on very specific segments of the capital markets; and use complex derivative instruments. This is the hypothesis that we test in this paper.
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