Put Into Perspective – How Small Hedge Funds Outperform Bigger Rivals by Skenderbeg Alternative Investments
Bigger hedge funds didn’t do as well as smaller ones over a recent 20-year stretch, and that disparity was even more pronounced during the 2008-09 financial crisis. So concludes a working paper by three finance professors at City University London. Among investors, however, “the demand has been for larger funds,” says Nick Motson, one of the paper’s authors. As of Oct. 31, an estimated 90% of the nearly $3 trillion of global hedge fund assets was in the hands of firms that manage more than $1 billion, according to HFR, a Chicago firm that tracks the industry. In contrast, firms overseeing less than $100 million accounted for under 5% of total assets. And roughly two-thirds of hedge fund assets are managed by the top 6% of all hedge-fund firms.
Motson and two colleagues, Andrew Clare and Dirk Nitzsche, crunched hedge fund returns stretching from January 1995 to December 2014. In all, they analyzed 7,261 funds, including those that had closed over that span, to avoid survivorship bias. They found that the largest funds—those in the top decile based on assets under management—returned 0.61% per month, on average. That’s below the monthly re-turn of 0.75% for the funds in the bottom decile for assets. On a yearly basis, the behemoths averaged a 7.32% return, versus 9% for the smallest portfolios.
That’s a pretty sizable gap, particularly since the larger funds typically market themselves as offering better infrastructure, including risk management, technology, and compliance capabilities, than do smaller funds. And they usually have more cachet, with recognizable-name partners. One possible explanation for the performance disparity, says Motson, is that the bigger a fund gets, the more closely it correlates with the overall market. “And there’s only so much money you can put into your best ideas,” he notes. Of course, the object of many hedge fund strategies is to zig when the stock market zags, in order to offer ballast to a portfolio. The numbers, also, are merely averages.
Scott Schweighauser, president of Aurora Investment Management, a nearly $8 billion fund of hedge funds, says that the paper’s findings make sense, though he’s agnostic when it comes to investing in a hedge fund based on size. It’s important to understand the fee structure of hedge funds, which mainly generate revenue from two sources: a management fee, often 2% of assets under management, and an incentive fee, typically a 20% cut of the fund’s profits. Smaller funds, Schweighauser says, are “much more attuned to generating returns that capture that incentive fee” because of their size. But, “as firms grow, the management fee becomes a much larger [part] of the overall revenue stream.” Indeed, 2% of $20 million is a lot less than 2% of $3 billion. Schweighauser argues that a bigger firm with a more cautious, less vola-tile approach can work well, provided that it is what investors want.
Managing a lot more assets, however, can change a hedge fund firm’s DNA, says Peter Borish, chief strategist at Quad Group, which helps smaller hedge funds with back-office functions, funding, and other support. He likens many of the large funds to a “supertanker” that isn’t “nimble.” There’s also a tendency for larger funds to be more risk averse, says Borish, who worked for Tudor Investment for a decade with the firm’s founder, Paul Tudor Jones. “If I take a risk and I’m wrong, I may lose assets,” he says of the mind-set of some bigger funds. Borish also says that those in a position to allocate money tend to prefer established brands, which are easier to justify when there’s a blowup, compared with when a small, newer fund runs into trouble.
The working paper, meanwhile, also found that larger funds trailed smaller ones during periods of financial stress, most notably the 2008-09 downturn. In 2008, for example, the funds in the tenth, or smallest, decile by size, outperformed the largest funds by 0.8% a month—losing 0.48% per month to the bigger funds’ 1.28% monthly shortfall. Annualized, that’s a 9.6% difference, a big discrepancy.
Schweighauser surmises that being nimbler and more reliant on their annual incentive fees may have enabled the smaller funds to do better than the bigger ones during that period of tumult. Smaller funds “are keenly focused on maximizing that incentive fee, which is a larger com-ponent of their revenue stream” than it is for bigger funds. He still believes that each fund needs to be evaluated individually. “One hundred million could be too much for someone, but $10 billion might not be enough for someone else,” Schweighauser says. “It all depends on the strategy and the manager and the investment dynamics at the firm.”
Motson, however, isn’t so sure: “This trend of just investing in the largest funds is probably flawed,” he says.
UBS says investors favor hedge funds as bond returns lackluster
Institutional investors seeking higher returns and portfolio diversification are allocating more to hedge funds as interest rates remain low, according to the chief investment officer of the hedge-fund platform at UBS Group AG. Those allocations are generally in the high single dig-its and can be as much as 20 percent, Bruce Amlicke, CIO at UBS Hedge Fund Solutions, said in an interview in Singapore. Five years ago, that share was “a couple of percent less,” he said without elaborating.
“Monetary policy responses to drive interest rates lower pushed fixed-income markets and yields to a level where you can look at hedge funds as an alternative to fixed income,” Amlicke said. “It’s a global phenomenon.” US treasuries returned 4.7 percent in the three years through the end of 2014, according to the US Treasury Master Index compiled by Bank of America Corp. That compares with a three-year return of 22.2 percent for the Eurekahedge Hedge Fund Index. This year, treasuries have returned 1 percent, less than half of the gains in the Eurekahedge index.
“The expected returns of investing in hedge funds are not the 10-plus returns of yesteryear,” said Amlicke, who heads the $34.4 billion UBS hedge-fund platform that invests in 230 funds globally. “What people are hoping to capture in the zero-interest rate world, is Libor plus 400 basis points and then mitigating some of the risk of fixed-income and equity markets.”
The importance of due diligence and manager selection
One of the most appealing aspects of alternative investments is that they’re alternative to the major broad-market indices, allowing investors to increase their diversification through reduced correlation to traditional asset classes. The flip-side of this attribute is that alternatives don’t really fit into a Morningstar “style box,” and this makes them difficult to evaluate against “similar” strategies – or to even determine which strategies are actually similar.
How should one compare and benchmark alternative funds? This is one of the questions explored in a new white paper by Steben & Company CIO John Dolfin and Senior Portfolio Manager Christopher Maxey. Titled “The Importance of Manager Selection within the Alternative Investments World,” the paper focuses on the role of fund of funds (“FoFs”) in selecting alternative investments, and it looks at how inves-tors might conduct due diligence on their own.
The Role of Fund of Funds
“A quantitative comparison of alternative managers must be supplemented with solid qualitative due diligence and a diversified set of managers,” according to Messrs. Dolfin and Maxey. Historically, FoF firms have filled this role for many investors, as FoFs have the experience and scale to conduct proper due diligence and to provide appropriate manager diversification.
In order to provide investors with a “resilient return stream across a variety of different market environments,” FoFs must excel in two areas:
- Manager selection
- Portfolio construction
According to the paper’s authors, not all FoFs are equally proficient at both of these vitally important aspects of FoF management. Those that are, however, are certainly worth their fees, as they can help investors avoid “bad apple” hedge funds that take unacceptable risks or are “outright frauds.”
Authors Dolfin and Maxey conclude their white paper by comparing FoF managers to expert auto mechanics – you might be able to select investments on your own or repair your car “DIY,” but most investors and drivers are probably better outsourcing the most specialized tasks to trusted experts.
For more information, download a pdf copy of the white paper.
See full PDF below.