Are Smaller Hedge Funds Best?

by Carla Johnson, Investors Offshore, London

03 April 2002

It has become conventional wisdom in the hedge fund world that small funds perform better than larger ones, but more and more professionals are beginning to question whether people came to that conclusion simply because of some high-profile poor performers such as Soros Fund Management and Tiger Management.

After these funds were liquidated, many successful funds closed to new investors to ensure they did not become too unwieldy, and researchers started to focus on size as a determinant of fund performance, finding that smaller, newer hedge funds outperform their larger peers. The problem with the research is that it excludes funds that under-perform and fail before they start reporting their results to a database.

"I am not sure that the data is that good at this kind of question," says Michael Urias, executive director at Morgan Stanley's Quantitative Analysis Group. "It is clearly the case that if you have larger funds they are the survivors."

Mr Urias says, however, that size is a clear disadvantage with certain hedge fund strategies, such as bond arbitrage and other relative value strategies. In some of these small financial markets, relatively small amounts of money can swamp the arbitrage opportunities. Many successful funds in these sectors tend to close very early to outside investors for precisely this reason.

Some hedge funds of funds nonetheless focus on smaller, younger funds to take advantage of the perceived performance edge. "We are very firm believers that managers in the early stages tend to be more focused on the fund and tend to outperform because the fund equals the business," says Ian Wiley, a manager at GLG Multi-Manager Investments.

"Because ultimately an early stage manager is more focused on the success of the business, they are very wary of taking large risks," Mr Wiley explains. "With a smaller capital base they are also nimbler and can shift the portfolio more quickly."

Another problem with research into performance based on size is that the market has been changing very rapidly. Larger funds have now been forced to think hard about the challenges of size, and some have responded by creating multi-strategy structures which can replicate the performance of smaller funds.

Yer pays yer money and yer takes yer choice!

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