Opalesque Industry Update – Spring Mountain Capital, LP (SMC), an investment management firm that focuses on alternative asset investing, today announced the findings of a proprietary white paper, titled “The Relation Between Hedge Fund Size and Risk,” that discusses the declining benefits of hedge fund size. |
The white paper was co-authored by Haim Mozes, Ph.D, a senior consultant with SMC and an Associate Professor of Accounting at Fordham University in New York, and Jason Orchard, a Principal at SMC.
Investors are often drawn to large funds because of the supposed safety and liquidity advantages of size; however, this paper identifies a number of factors that increase a large fund’s risk profile relative to its smaller peers. Managers of large funds are confident that good performance will be maintained, therefore warding off investor redemptions, but “eventually, fund size will hinder performance enough to trigger a redemption cycle that has a strong negative feedback loop,” according to the white paper’s authors.
“Large hedge funds may be perceived as less risky than smaller ones, but our research and experience suggests that this focus may be misplaced; and in the future, the opportunity costs of investing in large funds may be higher and the safety benefit of investing in large funds may be lower than investors currently expect,” said Jason Orchard, co-author of the white paper.
“Today, there remain economic, policy, and investment uncertainties that are likely to require managers to be nimble and adjust exposures quickly. Size could be a significant deterrent if this environment continues or were to worsen,” Mr. Orchard added.
The white paper also highlights:
• Large funds tend to generate lower alpha than smaller funds and tend to exploit market volatility to a weaker degree than do smaller funds. Large funds compensate for their lower alpha and inability to exploit volatility by having higher beta.
• Chasing returns is an ineffective strategy. The period in which a fund raises significant amounts of new capital may feature strong ‘alpha performance’, from the very effect of the fund putting that new capital to work. In turn, the strong performance may lead to additional capital being raised. Thus, for a period of time, large funds can provide the impression of being able to successfully manage massive amounts of capital. Ultimately, however, the fund-raising cycle stops, performance weakens, and investors begin redeeming.
• Large funds have the ability to sustain poor performance before closing for a longer period of time than do small funds.
• Large funds typically underperform their peer group for more than three years prior to closing and a decline in fund-raising typically precedes a fund’s performance decline. For smaller funds, the decline in fund raising typically follows a decline in performance.
• In current markets, funds in the 90th percentile of reported assets under management (approximately $750M) offer very little marginal benefit from increased size.
“Ultimately the research concludes that very large hedge funds may eventually have to transition to a private equity model, where capital is locked up for long periods of time, or to an investment banking model, in which capital is permanent and accessible via the public markets, in order to avoid closing,” said Dr. Mozes. SMC’s extensive methodology included analyzing Hedgefund.net’s database of live and dead funds (funds that have ceased reporting), which contains performance data for 7,545 live and 8,916 dead funds from 1995 through May, 2010. In the white paper, SMC defines large hedge funds as those funds than rank in the 75th percentile and above for reported assets under management. All hedge funds under the 25th percentile of assets under management are defined as small throughout the paper.