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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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