Early last week, we told you about an annual study of the performance of young vs. “tenured” hedge funds and of small vs. large hedge funds. The data provider Pertrac found that, in keeping with previous years, the young bucks post higher returns than their tenured cousins and that the small funds beat the large funds. But what about alpha? The study did not identify whether much – or any – of that relative out performance was alpha. Young and small funds might have simply been more levered to equity markets. After all, why wouldn’t they? The only way to attract investor attention is often to post eye-popping returns. If the market flounders, well, it was worth a try…
But another study published this month by the hedge fund unit of Bahrain-based alternative investment manager Investcorp found that “emerging” hedge funds (those with less than a three year track record) do in fact produce more alpha than “large” hedge funds (those with $5 billion of assets under management). The firm did not distinguish between young and small funds, opting instead to aggregate them together.
Authors Deepak Gurnani, Ludger Hentschel, and Niraz Shah note that according to industry estimates, nine of out every ten dollars invested in hedge funds last year was put into funds with more than $5 billion, yet those funds represent only 3% of all funds. At this rate, the much reported industry consolidation in Hedgistan appears set to continue for some time.
Not only did the trio regress each category of funds (“emerging” and “large”) against the S&P 500, but they also did so against the HFRI and finally against each HFRI sub-index. Over the past 5 years, emerging managers produced an average of 0.6% alpha per annum when regressed against the broad HFRI Index and an average of 0.8% when regressed against each appropriate sub-index. By contrast, the “large” funds produced -1.1% alpha when regressed against the HFRI and -1.0% on average when regressed against each appropriate sub-index. (Note: The authors accounted for the usual database biases such as “instant history” and survivorship).
So chalk one up for the new guys.
But wait. Gurnani, Hentschel, and Shah found that this was more of a horse race than first meets the eye. In fact, large funds actually produced more alpha in 2009 than the young bucks.
But check out what happened in 2008 and 2009. Sure, 2008 was a bad year, but emerging managers held their own relative to their sub-strategy indices. Although 2009 saw a major bounce back for hedge funds, large funds continued to perform poorly relative to what you would expect given their betas. And through it all, emerging funds produced positive alpha year after year, prompting Gurnani, Hentschel, and Shah to conclude:
If investors are seeking safety in large hedge funds, these funds appear to be failing their clients precisely during the periods when safety is most valuable.
Alas, not all emerging funds produce more alpha than their large competitors. As the chart below, created from data in Table 8, shows, large funds seem to have an advantage when it comes to hedge equity strategies in various geographies. We ranked the various strategies based on the relative outperformance of emerging managers (in terms of annual alphas over the past five years). We shaded the strategies that seem to favour the little guy in blue and those that seemed to favour the large funds in red. Note, however, that the strategies where large funds excelled are almost all ones that produced negative alpha (save for European hedged equity strategies and, to a small extent, event-driven strategies).
Of course, to calculate these alphas, the authors first needed to determine the beta to their respective sub-strategy indices for the emerging and large funds. The chart below, also created with data from Table 8, shows the five-year betas for each category. We ranked the sub-strategies on the basis of the gap between betas for each of two categories: the sub-strategies where emerging funds had a higher beta are shaded in blue and the sub-strategies where the large funds had a higher beta are shaded in red.
We were immediately struck by how much higher the large fund betas were than the emerging fund betas. You might assume that this is because the large funds are so large they must “become” the market (or, in this case, “the strategy“) while emerging funds are free to ply their trade within certain niches of the market.
Why do emerging managers appear to produce higher returns, lower betas and higher alphas? Apparently it’s not actually a result of higher risk-taking since the aggregate volatility of the emerging managers was lower than that of the large managers (and not, in case you were wondering, because there were more emerging managers to diversify-away the risk). Instead, the trio hypothesizes that it could be due to the capacity-constraints faced by large managers or simply because “emerging managers may have especially high incentives to succeed.”
A final observation. The paper also regressed each category of sub-strategy against the S&P 500. Emerging managers once again had a lower beta. Assuming that a higher portion of returns are the result of idiosyncratic risk for the emerging managers (vs. large ones), then ceteris paribus the emerging managers are a cheaper source of alpha. Considering that beta is virtually free for large investors, the emerging manager can spread the total fee across a larger pool of alpha dollars than can the large manager (the lion’s share of whose returns are the result of beta).
Higher alpha, lower fees, lower vol, higher returns. Sounds like the young guns may be on to something!