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Biggest is best but small funds with a good Sharpe Ratio could join the USD1bn club

By James Williams – Preqin has released its latest Hedge Fund Spotlight report, looking at how hedge fund performance varies by size; a useful exercise and certainly one that can help institutional investors steer a course when deciding the type, size, and style of managers to allocate to.

The results generated by Preqin were based on its award-winning Hedge Fund Online service, as well as interviews conducted in June with 300 hedge fund managers.

For some time now, institutional investors have dominated capital inflows into hedge funds. They make up approximately two thirds of the capital base and with that comes an incredibly skewed distribution curve, with over 80 per cent of institutions invested in large managers with USD1 billion or more in assets. 

Not that this should be altogether bad news for smaller managers running between USD100 and USD500 million in AUM. As Preqin’s research shows, seasoned hedge fund investors such as private wealth managers that have built hedge fund portfolios over a number of years are far more likely to consider a lower AUM threshold. Some 85 per cent of wealth managers, 79 per cent of family offices and 73 per cent of endowments said that they would consider investing in emerging and small managers. 

This is understandable given the favourable fees on offer and, critically, the fact that many remain open to investment; a massive problem at the opposite end of the spectrum where so much money is concentrated in such a small universe of billion dollar managers. Given that many of the most popular blue-chip managers to new investment, the only viable alternative is for institutions to write a significant ticket and hope that the manager will agree to running a segregated managed account. 

Preqin’s results show that over 90 per cent of emerging and small managers are open to investment. The average management fee of a small manager is 1.55 per cent compared to 1.63 per cent for a large manager, whilst the average performance fee is 19.32 per cent compared to 19.70 per cent; not a huge difference, but enough to persuade sophisticated hedge fund investors to look at managers at this end of the spectrum. 

By contrast, newer, less experienced investors such as private pension plans are far less inclined to look at managers with less than USD500 million. Indeed, more than half of these pensions (53 per cent) will only consider medium and large managers. 

The obvious question to raise here is how performance stacks up; what is the risk/return profile of the average large manager versus a medium or small manager? Preqin’s research finds that on a risk-adjusted basis, the big hitters are actually living up to their expectations, having produced the highest three-year annualized returns (through June 2015) with the lowest volatility. 

Good news indeed for the pension plans!

Between December 2011 and June 2015, large funds have generated an impressive Sharpe Ratio of 2.84, dispelling the oft-cited myth that smaller managers are better alpha generators because they can move more nimbly in and out of markets. To some extent this will be true, but as with everything in the hedge fund industry, there will always be good performers and bad performers. For small funds, the average Sharpe Ratio is just over 2.5. 

What does this tell us? To my mind, it shows that managers who have successfully built their track record over a period of years beyond USD1billion have done so from being strong performers from day one. They are the cream of the crop. Collectively, they are able to generate better, more consistent returns as compared to small or even medium funds, where the performance profile is more diverse, thereby lowering the overall Sharpe Ratio.

From a risk-adjusted return perspective, large funds are top left when one plots three-year volatility against annualized returns; the average large fund has generated north of 10.5 per cent, with the lowest volatility (less than 3.1 per cent). This is what has helped them produce a strong Sharpe Ratio, demonstrating their investment skill. 

Small funds actually fare better than medium funds, generating 10.05 per cent returns compared to approximately 9.1 per cent with a comparable degree of volatility (approximately 3.15 per cent). The trick for endowments and private wealth managers, therefore, is to discover which of these small funds have the potential to become the next billion-dollar fund. It is much harder to dig out these gems, which is why the large pension plans, partly due to protect their own reputations, naturally gravitate to large funds with demonstrable multi-year track records. 

This study by Preqin is very insightful. It suggests that the biggest really is the best. Perhaps as pension plans become more sophisticated, potentially by building out their internal resources to research hedge funds, the next generation of top performing small funds will attract a slug of assets previously earmarked for large funds. 

In my opinion, small fund managers that have had a rocky year, or a dip in performance, should redouble their efforts on improving their Sharpe Ratio. Don’t obsess with going out fund raising. 

Focus on performance and there’s every chance that a large institutional ticket will one day arrive.

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