Sunday, August 14, 2016

Optimal size for hedge funds - Big is not better

Investors like big hedge funds. They offer better infrastructure and usually are able to better meet operational due diligence standards. Big funds will have better client service. But bigger funds will miss on the essence for their existence - performance. Hedge funds show diseconomies of scale and investors chase winners. This has been well-documented with mutual funds, but with incentive fees the expectation is that diseconomies of scale would not be an issue. In fact. size does matter and not for the better.

A recent paper that explores the optimal size issue was published in the Journal of Finance, "The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers", by ChengdongYin.  It extends work that we have highlighted on the money management and incentives. (See "Competitive Asset Management and Why Focus on Less Popular Managers".) The simple fact is that there are incentives for managers to size their funds based on their fee arrangements. High management fees relative to incentive fees will have managers push for growth even if it negatively affects performance. The current combination of management fees and incentive fees for hedge funds does not solve this problem.

Yin's research shows that the diseconomies of scale vary by investment style. Some styles have more diseconomies than others. For example, emerging markets, global macro, managed futures, and long/short equites all show diseconomies. Managers will continue to grow until that push their returns down to the style averages. Be with the crowd and then just collect your fees. The diversification of the manager is no help. This provides an incentive to grow one fund until you get the diseconomies and then start another to repeat the process.

The message is the same as with mutual funds. If you want to find the exceptional managers, go small and when the manager grows to a certain size, sell, and repeat the process.  This takes work be the number suggest that there is potential reward.

No comments: