Investors are better off investing in small hedge funds in times of crisis

A paper released this month finds that there is a strong, negative relationship between hedge fund performance and size. Andrew Clare, Dirk Nitzsche and Nick Motson from the Sir John Cass Business School in London used a more comprehensive dataset than previous authors in this area, they say, to revisit the relationship between hedge fund performance and size.

In their paper called Are investors better off with small hedge funds in times of crisis?, they claim that they also found that in the last 20 years, and through the two recent financial crises (the collapse of the high tech bubble and the more recent global financial crisis), investors would have gained more with smaller hedge funds than with large ones.

They tested the hypotheses that capacity constraints and associated diseconomies of scale are more likely to be found in the hedge fund industry than the mutual funds industry. This is because hedge fund managers employ highly focused strategies, use leverage, invest in illiquid assets, concentrate on specific market segments and use complex derivatives.

They used the TASS database of more than 7,000 funds, with data spanning the period between 1994 and 2014. The largest decile of hedge funds in 1994 had an average AuM of little more than $300m, compared to $1.6bn at the end of 2014. "It is possible then, for a number of reasons, that the relationship between hedge fund size and performance has changed over time, or even that it changes with the financial market environment," they note. So they employed a methodology that allowed them to investigate the relationship at it changed over time.

They also documented clear cross-sectional variation by broad hedge fund strategy and found that the relationship between size and performance is positive for the Managed Futures hedged fund strategy.

There is also a negative relationship between age and perfor......................

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This article was published in Opalesque's New Managers a top-down monthly analysis, news and research publication on the global emerging manager space.