When it comes to hedge fund performance, does size matter?

What was a cottage industry in the early 1990s, the hedge fund sector has since grown into a huge global business. Hedge funds are now a well-established component of many institutional investors' portfolios.

Investing in hedge funds is attractive because hedge fund managers have the willingness and skills to pursue and achieve high returns. However both industry experts and academics have questioned whether performance might deteriorate as the size of assets under management (AUM) grow.

Using data spanning the period from 1994 to 2014, new research by Cass Business School's Centre for Asset Management Research explores the idea that there is a relationship between hedge fund size and performance.

Hedge Fund Performance measured against Size of AUM

The study showed clearly that on average the greater the size of the fund, the lesser the performance (Figure 1). Other things being equal, the results showed that on average a $200m hedge fund could be expected to outperform a $1bn hedge fund by 0.61%pa and a $5bn hedge fund by just under 1.25%. These are significant differences in performance. Professor Andrew Clare, one of the three academics who worked on the research, said "Our results clearly indicate that hedge fund managers in most sectors of the industry do not benefit from significant economies of scale. In other words, increasing size can impede performance." Reasoning why this may be, he continued "It is possible that each hedge fund manager has only a limited set of 'good ideas' and as the fund increases in size, they have to incorporate other less profitable ideas."

These results were generated by looking at all hedge funds but there are many different hedge fund strategies, in which managers may face specific capacity constraints. Therefore the research also looked at some of the most popular hedge fund strategies, Event Driven, Managed Futures and Long/Short strategies, to determine whether strategy-specific factors play a role in the relationship between size and performance. The results suggested that Long/Short managers face more significant capacity constraints than managers of other strategies. Interestingly though they also suggested that Managed Futures funds can benefit from significant economies of scale.

The researchers also explored whether the relationship between performance and size changed over time. Estimating the relationship between hedge fund AUM and performance on a year-by-year basis they discovered that the negative relationship was particularly pronounced during periods of market stress. This is a surprising find, as one might expect size to be an advantage during such times.

There may be a number of explanations for this phenomenon. First, the AUM of larger hedge funds would tend to comprise more potentially flighty fund investments; and the flight of such money from the industry may have hampered fund performance as they dealt with large redemptions, rather than on their investment strategies. Second, it could be that smaller hedge funds had more stringent gating arrangements that limited the potentially damaging impact of redemptions during these periods. Lastly, it may simply be that smaller hedge funds have less market risk embedded in their portfolios.

This research, the most comprehensive study of the industry so far, was commissioned by global investment advisors, Gatemore Capital Management. Liad Meidar, Managing Partner at Gatemore, commented: "As specialists in hedge fund selection, we have observed that smaller funds tend to outperform on a risk-adjusted basis. While it was not surprising to see this confirmed by the study, we were surprised by the performance of smaller hedge funds during crisis periods. It is often that case that the bigger the hedge fund, the farther away the head portfolio managers are from the security-level analysis. This makes a significant difference when it comes to many strategies.

"The outperformance of smaller funds during crisis periods perhaps could be explained by the fact that many larger funds provide more liquidity. During times of stress, investors may tap the larger hedge funds as a source of liquidity - which forces the larger funds to sell during a time when they want to be buying."

The final working paper version of the research can be downloaded at the link below.

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