Small Hedge Funds Lead the Industry

The debate around what comprises the “secret sauce” of hedge fund investing was ramped up to another level with the recent release of a PerTrac software study. As reported in the Financial Times, the controversial study suggested that small hedge funds, generally with less than $100 million in assets, outperformed both mid sized and large hedge funds. What is most impressive about the data is that the gap isn’t inconsequential either. The smaller funds earned a 15 year return (from 1996 to 2011) of 558 percent, compared to 356 percent and 307 percent for funds between $100 to $500 million and over $500 million respectively.

This sparked an immediate response from the large players in the hedge fund business, criticizing the statistical merits of the study. Patric De Gentile-Williams of Man Group’s FRM business told the Financial Post that, “there’s survivorship bias in the data in these reports despite rigorous attempts by people conducting the research to compensate for it.”

While some level of survivorship bias may be present in the study, perhaps there is some merit to the idea that a smaller firm could, on average, produce returns in excess of the market’s big players.

The Merits of Small Hedge Funds

The idea of investors with smaller portfolios producing greater returns is not a new concept to finance, and should not come as a big surprise to advanced investors. While the research capabilities of larger funds may provide some advantage, the amount of research available for purchase in today’s market really does level the playing field in this regard. Of course, large funds struggle to accumulate attractive positions without influencing market prices. While they may have the funds to go after bigger fish, often when they do, they drive up prices for themselves as well as others in the market. Small hedge funds can employ a more stealthy approach, accumulating their positions without drawing attention or boosting prices to the point where their returns are eroded.

Smaller funds are also more flexible in terms of the strategies they employ. Not only can they adapt quickly to market conditions with a leaner team and governance model, but they can adapt to their client’s needs more quickly as well.

Generally small hedge funds are in the earlier stages of their development, and may be employing new or innovative strategies that seize upon opportunities in the market. While bright traders at large funds can certainly be creative, smaller funds can maintain their niche strategies longer without drawing the attention that sometimes prices out such opportunities. Once an opportunity is exploited by a large firm to the point where it makes economic sense, often it is no longer attractively priced.

Smaller Funds Currently Lead the Market

These potential advantages seem to be attracting client money as well. Smaller hedge funds dominated the market in 2011, holding three quarters of total market share. Investors are attracted to the focused strategies that small funds can provide as well as the greater interaction with fund managers that simply isn’t possible with the large scale funds. Smaller clients simply can’t influence management decision making on the same scale when their holdings are insignificant amongst much larger players.

Does the Small Hedge Fund Trend Benefit Job Seekers?

For those seeking employment in the hedge fund industry, the news that smaller funds are taking up more market share and leading the way in returns is good news. The reality is that smaller funds are less efficient than their large peers. $500 million in client money managed by 20 funds requires substantially more employees than $500 million managed by one large player. This creates opportunities in the industry for qualified individuals.

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{ 1 comment }

Leigh November 16, 2012 at 2:25 pm

Patric is an extremely bright man and a good professional. However, it just becomes much more difficult to push $1 Billion + around. He says that because he is a seeder. It is in his best interest to grow funds to $500M – $1 B. There is a survivorship bias to these studies and an operational risk to smaller funds, but logically it is difficult to argue with the idea that less money means more nimble, less market impact.

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