Does Fund Size Matter?

Date: Thursday, December 4, 2008
Author: Irene Aldridge, ABLE Alpha Trading Ltd.

 Recent market turbulence has renewed the debate on the future of the hedge fund industry. Anecdotal evidence points to many hedge funds suffering severe losses and even closing shop. As a result, some industry observers think that the future belongs to large, institutionalized funds that have capital to withstand market volatility as well as achieve efficiencies of scale through aggregation of their reporting and other back office costs. Yet others believe that the future lies in innovation that can only be jump-started in small outfits undeterred by the risks involved in delving into uncharted investing landscapes. Whether or not the fund size influences performance of a hedge fund has been a hot area of academic debate as well.

One point that everyone seems to agree upon is that the key to hedge fund survival is the fund manager's ability to generate consistent positive performance. The question of what is the best measure of performance, however, has been a subject of contention.

Traditionally, performance is measured by one or more of the following three metrics: the absolute return on capital, Sharpe ratio, and alpha. While other performance ratios and risk measures have sprung up over the years and are rapidly gaining popularity, the three old metrics are dependable workhorses of performance reporting.

The absolute return on capital, after fees and transaction costs, provides a single coherent number that readily lends itself to fund comparison. The problem with using the absolute return as a measure of hedge-fund performance, however, is two-fold:

1. The absolute return does not account for risk inherent in the investment. High risk increases the probability of fund "blow-up" and similar unwelcome events.
2. The absolute return does not relate whether the measured performance is truly due to the manager's skill, or whether it is due to the manager's odd luck in entering and riding a particular speculative bubble. In case of the latter, are the manager's fees justified or can investors replicate the manager's strategy at a fraction of the cost charged by the hedge fund manager?

The Sharpe ratio is the average monthly fund return on capital, less the risk-free rate, divided by the historical monthly standard deviation of the returns. The Sharpe ratio addresses the risk issue associated with the absolute return measure and, to a lesser extent, the opportunity cost issue absent form the absolute return metric. Although the computation of the Sharpe ratio is more involved than that of absolute return, it is used widely. Yet the applicability of Sharpe ratio has too been criticized for its assumption that the underlying returns are normally distributed (hedge fund returns are usually not normally distributed).

"Alpha" is the fund return that is due to fund manager's own skill, distilled from various market impacts and speculative bubbles. It is also known as the fund manager's idiosyncratic performance, and is intended to capture the manager's unique skill in navigating the markets. Alpha is the most computationally intensive measure of the three metrics presented here.

The relationship between fund size and fund performance turns out to depend heavily on the performance metric used. Thus, on the absolute return basis, small funds have been found to consistently outperform large funds. On the Sharpe ratio and Alpha bases, however, large funds have been shown to outperform small funds. (At least ten academic papers have been devoted to the subject of fund size influence on fund performance. A reasonably complete bibliography of academic literature on hedge funds can be found here.)

Several hypotheses sprung up that attempt to explain the documented discrepancies in fund size influence on fund performance. One surmises that hedge fund strategies tend to have finite capacities, and increases in capital may erode performance of strategies. Smaller funds may therefore be better positioned to fully take advantage of the fund's strategies without cannibalizing strategy performance by overinvesting. On the other hand, large funds have more power to negotiate lower transaction costs that extend strategy capacities. Finally, strategy capacities have also been shown to be independent of the fund size and depend squarely on fund manager's skills, with competent managers being able to continually further their research and development efforts to extend capacities of their strategies as well as to add new strategies with extra capacities to the mix.

Another hypothesis aiming to explain the observed discrepancies posits that the discrepancies are due to the bias in the hedge fund data used to construct hedge fund performance studies. Most studies are based on private databases that collect information voluntarily supplied by hedge funds, primarily for fund marketing purposes. Hedge funds that reach capacity and are not accepting new capital often stop reporting performance, skewing the results of the studies toward funds vying for new capital. Nevertheless, such databases are the few tools available to researchers and provide valuable information about development of the hedge fund industry.

While the consensus on the optimal fund size is yet to be reached in both academic and practitioner circles, funds are likely to undergo metamorphosis in the wake of the latest crisis. The latest data on surviving hedge funds will undoubtedly enhance industry's best practices and potentially change course for some funds.

Irene Aldridge is Quantitative Portfolio Manager and Managing Partner at ABLE Alpha Trading Ltd. She can be reached at ialdridge@ablealpha.com.