New Research Belies Large Hedge Funds’ Perceived Safety

Heard before: Chasing returns doesn't work

Investors who are attracted to large hedge funds because of their supposed safety and liquidity advantages may want to consider research results contained in a proprietary white paper released Thursday by Spring Mountain Capital as part of their due diligence before investing.

The paper, “The Relation Between Hedge Fund Size and Risk,” discusses the declining benefits of hedge fund size.It was written by Haim Mozes, a senior consultant with Spring Mountain who also teaches accounting at Fordham University, and Jason Orchard, a principal at the firm.

In their paper, Mozes and Orchard identify several factors that increase a large fund's risk profile relative to its smaller peers, according to a statement by Spring Mountain. They find that managers of large hedge funds are confident they will maintain good performance, thereby warding off investor redemptions, but "eventually, fund size will hinder performance enough to trigger a redemption cycle that has a strong negative feedback loop."

The authors find that although large funds may be seen as less risky than their smaller counterparts, research and experience says otherwise. Indeed, "in the future, the opportunity costs of investing in large funds may be higher and the safety benefit of investing in large funds may be lower than investors currently expect," Orchard said in the statement. "Today, there remain economic, policy and investment uncertainties that are likely to require managers to be nimble and adjust exposures quickly. Size could be a significant deterrent if this environment continues or were to worsen."

The statement highlights these findings from the white paper:

  • Large funds tend to generate lower alpha than smaller ones and exploit market volatility to a weaker degree. Large funds compensate for their lower alpha and inability to exploit volatility by having higher beta.
  • Chasing returns is an ineffective strategy. The period in which a hedge fund raises significant amounts of new capital may feature strong alpha performance from the very effect of the fund putting that money to work. The strong performance, in turn, may attract additional capital. Thus, for a period of time, large funds can create the impression of being able to successfully manage massive amounts of capital. Ultimately, however, the fund-raising cycle stops, performance weakens, and investors begin redeeming.
  • Large funds can sustain poor performance for a longer period of time before shutting down than small funds can.
  • Large funds typically underperform their peer group for more than three years prior to closing, and a fund-raising decline typically precedes a fund's performance decline. For smaller funds, the decline in fund raising typically follows a decline in performance.
  • In current markets, funds in the 90th percentile of reported assets under management (approximately $750 million) offer very little marginal benefit from increased size.

Mozes said in the statement: "Ultimately the research concludes that very large hedge funds may eventually have to transition to a private equity model, where capital is locked up for long periods of time, or to an investment banking model, in which capital is permanent and accessible via the public markets, in order to avoid closing."

Spring Mountain's methodology included analyzing Hedgefund.net's database of live and dead funds (funds that have stopped reporting), which contains performance data for 7,545 live and 8,916 dead funds from 1995 through May 2010. In the white paper, the researchers define large hedge funds as those funds than rank in the 75th percentile and above for reported assets under management. All hedge funds under the 25th percentile of assets under management are defined as small throughout the paper.

Founded in 2001 and located in New York, Spring Mountain Capital is a private investment management firm that focuses on alternative asset investing and offers a wide range of investment strategies.

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