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Why Largest Hedge Funds Gobble Up the Most Capital (but Not All of It)

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Large hedge funds, which represent a large majority of institutional capital allocated to the sector, outperform their small counterparts, according to a new report from Preqin, the alternatives data provider.

Despite a loss of 1.5% in August, funds with $1 billion or more in assets under management have generated a 12-month return of 4.3%, a three-year annualized return of 9.1% and a five-year annualized return of 8.5%. They also had the lowest three-year volatility of any size class, only 3.3%. Their Sharpe ratio was 2.84.

In contrast, hedge funds with less than $100 million in assets had the lowest returns across all timeframes, as well as the highest volatility.

These findings are significant, as 82% of institutional capital allocated to hedge funds today is invested in large vehicles, according to Preqin. Small and emerging funds, those with less than $500 million in assets, have only 11% of capital commitments.

The findings were derived on Preqin’s recently released fund size benchmarks, which assess the performance of hedge funds based on asset size.

Preqin noted that big funds were successful because they had built up their asset bases over an average of 12 years. Early on, they were able to stand out from their peers with strong performance, eliciting capital commitments from investors that enabled them to thrive.

Still, only 11% of investors are willing to allocate exclusively to the biggest funds, according to Preqin. Smaller funds appeal to allocators for several reasons.

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For one thing, even though small funds produce wildly varying results, the best-performing ones can generate better returns than their larger brethren.

“The highest performing funds of smaller sizes can generate returns greater than their larger counterparts, which means that smaller hedge funds can still hold much appeal for investors,” Preqin’s head of hedge fund products Amy Bensted said in a statement.

In addition, they typically charge lower fees that the biggest funds, which can demand higher ones thanks to their strong risk-adjusted returns, longer track records and greater investor appetite. Emerging funds charge a median 1.55% management and 18.84% performance fees, compared with large funds’ 1.63% and 19.7%.

Redemption periods at smaller funds are also shorter, an average of 51 days for emerging funds and 104 days for large funds.

Also, early investors in a smaller fund may be able to hold on to favorable terms and conditions if a fund becomes successful.

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