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One of the next growth opportunities for the hedge fund industry may be the retail market, as investors increasingly seek out alternative asset classes. With analysts predicting that retail assets for the industry will climb to $940 billion over the next four years, from only $305 billion at the beginning of 2013, this represents a major opportunity for hedge funds, if they met these lofty expectations.

The Financial Times argues the trend is a convergence of traditional asset managers seeking out products with higher returns and hedge funds looking for additional capital. The demand from asset managers is a result of the struggle to offer alternative products to compete with low fee exchange traded funds (ETFs). While hedge funds certainly don’t offer lower fees than ETFs, they do offer strategies that can be marketed as unique and advantageous for investors. This is especially true in comparison to active equity or bond funds that as a whole haven’t been able to justify their fees in comparison to their ETF peers.

Mutual Fund Firms Snap Up Hedge Fund Managers while Retail Funds Launched

The mutual fund industry has been quick to move into the hedge fund space in order to establish a presence. Franklin Templeton was one mutual fund giant that was active in the hedge fund space, acquiring a majority position in K2. Legg Mason also was involved, adding Fauchier Partners to its group.

While these managers have been busy making acquisitions, hedge fund managers have been launching retail-oriented funds on a more frequent basis. Highbridge and AQR have recently released their own retail funds, while KKR has launched a fund to be distributed to retail clients by Charles Schwab. All of this stacks up to increasing pressure on the traditional mutual fund industry.

Shift in Fee Model May be Behind the Movement

One of the leading factors in the increased interest in retail hedge funds may come from how asset managers are compensated by their clients. Sandy Kaul, head of business advisory services for Citi Prime Finance, told the Financial Times, “In the US wealth adviser market there has been a shift in the pay structure, away from fee-based commissions over the past 10 years, and an increase in fees on assets under management.” As a result, wealth managers are looking to hedge funds to preserve asset value, and therefore, their fee revenue.

What are the Implications for Hedge Fund Job Seekers?

The potential for large scale retail acceptance of hedge funds is an important development for those currently in the industry or potentially seeking future opportunities. Many analysts have wondered where exactly future growth for the industry would come from, and in the past, retail investors would have seemed like a long shot. But recent regulatory changes and growing enthusiasm from money managers seems to be changing that belief. Retail hedge funds are increasingly viewed as a core component of future wealth management offerings. As a result, the increased growth potential of the industry should come as welcome news for those in the industry or considering a future in hedge funds.

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The performance of hedge funds based on relative size has been a topic of discussion for several years. Many studies have been published attempting to determine whether fund size is a key indicator of expected returns. In order to add additional information into this debate, recently took a look at the results of 3,000 funds spanning both small and large hedge funds. Their results are thought provoking, showing that in fact smaller funds did outperform larger funds, and remarkably, by a sizable margin.

The survey focused on hedge funds using long/short equity strategies in order to remove any bias stemming from differences in strategy related returns. The 3,000 firms studied were then split between those with $50 – 500 million in assets under management, which were described as small, and over $500 million, which were described as big. The two buckets were essentially even in the number of funds represented. What was the result? The smaller firms posted better returns, topping “big” funds by 2.54 percent over the last five years, and 2.20 percent over the last ten years. These are fairly remarkable gaps that are very meaningful to hedge fund investors.

Small Returns Provide Higher Returns, but Also Higher Variability

While small firms may have outperformed larger firms, there was a greater distribution of results among those with fewer assets under management. This shouldn’t be surprising, as some small funds are designed to exploit certain niche strategies within the long/short segment that may over- or under-perform the asset class as a whole. Larger funds, on the other hand, generally attempt to align their returns with benchmarks, avoiding large variations.

Many investors would believe that a small fund may be more willing to take risk, whereas big funds would generally demonstrate a risk adverse stance towards its investments. The result of this study actually disagrees with that notion. In nearly every year, the worst small funds outperformed the worst large funds. This likely suggests that the excess returns offered by smaller funds is not being offset by a greater risk of loss, at least not during the period studied. It seems as though the excess returns provided by smaller funds are real alpha, and not just additional risk taking.

Leading Hedge Fund Professionals Often Leave to Start Small Funds

One of the proposed reasons behind the differential in returns based on hedge fund size is the self-selection of small fund managers. Most of the small hedge funds are run by managers that previously had success operating in large funds. Unsuccessful managers in big firms would struggle to raise capital without a sound track record, and therefore are unlikely to be represented in the smaller fund group. The successful managers also generally have committed their own capital to the fund, sometimes in a very substantial way, which differs from most managers at large hedge funds and may provide additional motivation for some managers.

In addition, both managers and staff at smaller hedge funds likely have their compensation tied more closely to the fund’s results, sometimes with their bonuses greatly exceeding base salaries. While it’s certainly possible for large hedge fund managers to earn healthy bonuses, compensation is not as closely linked to performance.

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