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Which Horse to Bet On: The Advantages of Allocating to Large Funds

Wed, 27 Jun 2012 13:18:49 GMT

Which Horse to Bet On: The Advantages of Allocating to Large Funds

Much has been written and discussed about the advantages of small hedge funds, including PerTrac’s own study that shows smaller funds outperform larger ones.  Nimble and able to fly under the radar, small funds can traverse markets undetected.  Their modest size fuels a hunger to generate returns so that they can earn a performance fee to augment their basic management fee which, by itself, may not provide an adequate paycheck.  But what happens when markets sink? 
While the returns of larger hedge funds may not be as robust as those of smaller funds, smaller funds may be more vulnerable in volatile market environments.   During the 2008 financial crisis, for example, PerTrac’s index of large funds, those with AUM greater than $500 million, did not experience the same drawdown as its small fund index, which consists of funds with less than $100 million AUM.*  The large fund index ended the year down 14.10% compared to 17.03% for the small fund index. From 1996 to 2010, the large fund index has also been less volatile than the small fund index, as the following chart shows:
Annualized Volatility Measures by Hedge Fund Size Indices from Jan 1996 to Dec 2010
 
Other, more familiar, reasons investors might favor large funds over small ones include the fact that larger funds receive more money from their management fees (in absolute terms) so their internal operations are less likely to be affected by asset outflows.  Deeper pockets also mean that they can invest in the most advanced analytics systems to help with risk management. 
Large hedge funds also offer better investment scale to investors, allowing them to allocate more money into one large fund without dominating it. Investing in large funds can also reduce an investor’s due diligence workload (i.e. for asset allocation, it’s easier to perform due diligence on one large fund than several smaller ones). 
Finally, because of their higher management fee-related income relative to smaller funds, larger funds can afford more sophisticated reporting tools to improve transparency and provide a more customized level of service to their clients. 
So, for the investor who favors such attributes in an investment, the larger horse saddle might be the right fit.  
*Source: Impact of Fund Size and Age on Hedge Fund Performance. PerTrac, September 2011. 

Much has been written and discussed about the advantages of small hedge funds, including PerTrac’s own study that shows smaller funds outperform larger ones.  Nimble and able to fly under the radar, small funds can traverse markets undetected. Their modest size fuels a hunger to generate returns so that they can earn a performance fee to augment their basic management fee which, by itself, may not provide an adequate paycheck.  But what happens when markets sink? 

While the returns of larger hedge funds may not be as robust as those of smaller funds, smaller funds may be more vulnerable in volatile market environments.   During the 2008 financial crisis, for example, PerTrac’s index of large funds, those with AUM greater than $500 million, did not experience the same drawdown as its small fund index, which consists of funds with less than $100 million AUM.*  The large fund index ended the year down 14.10% compared to 17.03% for the small fund index. From 1996 to 2010, the large fund index has also been less volatile than the small fund index, as the following chart shows:

Chart: Annualized Volatility Measures by Hedge Fund Size Indices from Jan 1996 to Dec 2010

Annualized Volatility Measures by Hedge Fund Size Indices

Other, more familiar, reasons investors might favor large funds over small ones include the fact that larger funds receive more money from their management fees (in absolute terms) so their internal operations are less likely to be affected by asset outflows.  Deeper pockets also mean that they can invest in the most advanced analytics systems to help with risk management. 

Large hedge funds also offer better investment scale to investors, allowing them to allocate more money into one large fund without dominating it. Investing in large funds can also reduce an investor’s due diligence workload (i.e. for asset allocation, it’s easier to perform due diligence on one large fund than several smaller ones). 

Finally, because of their higher management fee-related income relative to smaller funds, larger funds can afford more sophisticated reporting tools to improve transparency and provide a more customized level of service to their clients. 

So, for the investor who favors such attributes in an investment, the larger horse saddle might be the right fit.  

 

*Source: Impact of Fund Size and Age on Hedge Fund Performance. PerTrac, September 2011

 

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