Is Larger Better With Hedge Funds?

by: Cam Hui, CFA

I received a number of responses from my post hedge fund shakeout continues that suggests that the current trend of size and consolidation seems to be the answer for the hedge fund industry. Indeed, the WSJ (subscription required) reported:

By the end of last year, 87% of all the money in the business was handled by funds managing $1 billion or more, and 60% was held by managers sitting on $5 billion or more. The dominance by the largest funds has been accelerating: In the past two months alone, the world’s largest public hedge-fund company, Man Group PLC, increased assets by $4 billion, to $78.5 billion.

Size is not a panacea

There are a number of problems with this approach by hedge fund investors. Firstly, while larger funds may be better positioned to weather downturns, a look at the hedge fund implode-o-meter shows large funds are not immune to blow ups.

In addition, as hedge funds gain in size, their capacity constraints will begin to kick in and the opportunity for alpha can diminish.

Fix the business model

The hedge fund industry doesn’t offer a good value proposition. Fees are too high and returns are getting commoditized. I wrote in the past that Bridgewater Associates reported that many hedge fund strategies could be replicated by simple passive strategies. For example, emerging market hedge funds could be replicated using a 50% weight in emerging market bonds and 50% emerging market equities – all without the high costs. Already, there is a mutual fund starting up to replicate hedge fund returns using ETFs (see announcement here).

Warren Buffett reportedly made a bet that the S&P 500 would beat any hedge fund of funds picked by the other bettor over a 10 year period. He believes that the high fee structure embedded in hedge funds would overcome any alpha generated.

Hedge funds used to be highly differentiated investment vehicles. Returns were good and un-correlated to other asset classes. You didn’t mind paying 2% and 20% or more for the likes of Soros or Tiger. Today, the returns are being commoditized. Size, which confers the benefit of economies of scale, is not an answer. The industry needs to fix its business model and value proposition.