Investors Shouldn't Avoid Smaller Hedge Funds

by: Nadav Manham

According to this article about Deutsche Bank's (NYSE:DB) annual Alternative Investment Survey, over 50% of hedge fund investors will only invest in funds with $1 billion or more in assets under management:

“It means that smaller hedge funds will disappear,” observes Andrew Ang, professor of finance and economics at Columbia University’s business school. Bigger funds are in a better position to have good risk management and can borrow more cheaply, he points out, and are more likely to have a track record.

“There is a magic number where economies of scale really kick in,” Mr. Ang adds. “It’s at about $2 billion to $3 billion. With funds smaller than that, it’s much harder to get significant rewards.”

I disagree with Professor Ang, and with any hedge fund investor that limits themself to $1 billion+ funds. Taking Professor Ang's points in turn:

1) Why are big funds in a better position to have good risk management? What does he mean by good risk management? If he means larger funds are more able to hire dedicated risk managers, I think that's more likely to provide only the appearance of risk management rather than the reality, as Ken Akoundi explains in detail. The ultimate guarantor of good risk management is when the investment process is joined at the hip with the risk management process, which is usually truest when one very competent person is doing both.

2) Bigger funds can borrow more cheaply than smaller funds. With "advantages" like this, it seems to me, you don't need disadvantages.

3) Bigger funds are more likely to have a track record. Yes, but fund size is a very lazy heuristic to use to screen for track records. If you the hedge fund investor wish to confine yourself to funds with longer track records--a legitimate aim--the way to do that is to screen for funds with longer track records, not to use fund size as a proxy for track record.

4) Larger hedge funds benefit more from economies of scale. Yes, but the benefits of these economies of scale accrue to the hedge fund itself, not to the hedge fund investors. If anything, hedge fund investors face diseconomies of scale as the size of their fund grows:

a) As a fund grows its universe of opportunities shrinks.

b) If a fund grows by adding new investors, those investors are less likely to share the investing philosophy and expectations of the original partners.

c) Because of a) and b), larger funds are more likely to experience unfavorable style drift.