It has been known for some time that in general smaller hedge funds outperform larger hedge funds. This is obviously a general rule with many exceptions, but the basic reality behind it is confirmed by the fact that nearly all hedge fund firms limit the size of their individual funds/strategies.
That said, there has also been a generally accepted belief that larger hedge funds were “safer” than their smaller counterparts, as they tended to be less volatile and were also more buffered in the event of a crisis or “black swan” event.
Recent academic research, however, is bringing this belief about the safety of larger hedge funds into question. Researchers at the City University in London say their study shows that smaller hedge funds actually perform better than large funds in crisis periods.
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Andrew Clare, Dirk Nitzsche and Nick Motson note in the abstract of their study: “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.”
Overview of the performance of hedge funds by size
Clare et al note that the performance of hedge funds has been analyzed by a number of authors who employ factor models based originally on the work of Sharpe (1992) to assess this performance (see Fung and Hsieh (1997), Agarwal and Naik (2000), or Gehin and Vaissie (2006) for early examples). That said, the potential in the hedge fund industry for diseconomies of scale led others to investigate the impact of size on hedge fund performance. The initial investigations into this relationship by Clarke (2003) using data between 1991 and 2001, by Herzberg and Mozes (2003) using data from 1996 to 2001 and by Gregoriou and Rouah (2003) using data from 1994 to 1999 did not find any significant variation by size.
Ammann and Moerth (2005) used a longer and more recent span of data from 1994 to 2005 to find evidence suggesting a strong negative relationship between fund size and performance. Moreover, using data on hedge fund performance from 1994 to 2008, Teo (2009) also offers strong evidence of an inverse relationship between hedge fund performance and size. Making adjustments for risk, Teo determines that that small hedge funds outperform large hedge funds by a notable 3.65% pa.
Smaller is better when it comes to hedge funds
The results of the study by Clare and colleagues make it clear there is a strong, negative relationship between hedge fund performance and size. Furthermore, the data show that during the two periods of financial crisis, other factors held equal, investors would have seen better returns with a small hedge fund instead of a large one.
In discussing their results, the researchers also highlight “clear cross sectional variation in this relationship by broad hedge fund strategy.” They point out, for example, that the relationship between size and performance is actually positive for the Managed Futures hedge fund strategy.
Note that Clare et al. used the Thomson Reuters’ Lipper Hedge Fund Database for their research as it contains accurate multi-year data on “live” and “dead” hedge funds.
See full study below.