Big is beautiful in hedge fund land, for now

More than ever, sovereign wealth funds and institutions are entrusting their money disproportionately to the largest hedge funds. They may find out bigger isn’t always better.

The size fetish has meant that the share of industry assets held by firms with more than $1 billion under management has risen gradually from about 75 percent in 2006 to about 82 percent at the start of this year, according to Hedge Fund Intelligence. And the trend seems to be accelerating. In the second quarter, 92 percent of net inflows went to managers with more than $5 billion under management, Hedge Fund Research reckons.

Yet research by PerTrac suggests that older and larger managers tend to deliver lower absolute returns than smaller and younger ones. Smaller funds in fact beat larger ones every year between 1996 and 2009, except for 2008. New managers are also more open to giving investors a better deal than is traditional, whether in terms of fund governance or fee structures.

Larger funds, meanwhile, may struggle to find opportunities big enough to make a difference. Or they may have to take more risk to generate the same returns. There’s also the danger that management fees bring in so much money that big funds may focus on accumulating assets rather than investing well.

So why are hedge fund punters so keen on size? One reason is that the investor base is changing. More money now comes directly from large institutions such as sovereign wealth funds and pension managers. These investors typically want brand name managers with plenty of resources, powerful management systems and diversified strategies. Large funds like that should be less likely to blow up because of one bad trade — and crucially, they fared less badly than smaller brethren in the crisis year of 2008.

But size and reputation are no guarantee of performance. Even big blue-chip managers such as Fortress and DE Shaw hamstrung investors by limiting redemptions during the turmoil two years ago. Happily for newcomers, start-up funds can still raise money from seed capital providers including the likes of Julian Robertson of Tiger Management. And the new breed of hedge fund investors should over time get more comfortable handing cash to smaller managers. Good thing too: they could lose out if they sideline small funds for long.