Practical analysis for investment professionals
19 May 2015

Small Hedge Funds Complement Large Ones

What is the next step for institutional investors that have already embraced investing in established large hedge fund managers? What are the benefits of embracing smaller emerging hedge fund managers?

Small Manager Funds Are an Institution’s Next Step in Hedge Fund Investing

Institutional investors have mostly disintermediated the large manager–focused fund of funds to go direct. The rationale is that they no longer need the largest funds of funds to find the largest hedge fund managers. This is sensible, cost-effective, and true. As the large, established hedge fund world has matured and become relatively more efficient, the value of paying a specialist an additional layer of fees is far diminished and the cost is far higher, both relatively and absolutely.

Although returns have compressed dramatically for the largest hedge funds, the dispersion of returns has remained wider among the smaller managers, allowing for a potentially greater value proposition in allocating to these smaller funds.

In this article, my contentions are twofold:

  1. Institutional investors who have successfully allocated to large established managers now need small managers to achieve true diversification.
  2. The optimal way to achieve this small manager diversification is through small manager–focused solutions providers in order to complement institutional investors’ large manager direct allocations.

Institutional investors, such as pension plans (both corporate and public), endowments and foundations, and sovereign wealth plans can be scarcely resourced. At the end of the day, they are divisions of organizations — or even governments — with other organizational goals far broader than more narrowly focused investment organizations. They are also unlike investment firms in that these divisions are often cost centers rather than profit centers.

Institutions Are Not Sufficiently Resourced to Evaluate All Opportunities

Between 2007 and 2014, institutional investors went from an average allocation of $500 million in two to three funds of funds to an average allocation of $2 billion to $3 billion directly to 10–25 hedge funds, having disintermediated the largest funds of funds focused on large established managers, according to the 2014 Preqin Global Hedge Fund Report.

Although it is relatively easy for one of these institutional investors to invest in one of the 367 largest hedge funds, defined as having assets of more than $1 billion, it is almost impossible to have the resources to evaluate the other 7,500 smaller hedge funds, with assets less than $1 billion. For perspective, this implies that 95% of the hedge funds by number have only 13% of the assets. This raises the question that if we agree that the largest established hedge funds are generally superior investments at least to long-only investments, why would one want to complement these with smaller emerging hedge fund managers?

Larger Hedge Funds Have Constrained Opportunity Sets

The answer to that question is as follows: Although there is a minority of hedge funds that launch with large assets under management (AUM), this is the exception. Most hedge funds start with small AUM. Funds that post outsized returns are more likely to be successful at asset raising, which, in turn, results in the funds becoming large. When hedge funds are small, they are able to invest in securities that larger funds may be precluded from investing in.

For example, when I was a portfolio manager at one of the world’s largest hedge funds, the goal was to find at least 1% positions (but, ideally, 2%–4% positions). On an asset base of $25 billion, that would imply $250 million for a 1% position and $1 billion for a 4% position. Now, let’s look at a $1-billion market cap company with a 100% float — it’s not a realistic assumption, but for simplicity let’s assume that is the case. That would imply 25%–100% of the company.

Never mind the fact that when a hedge fund holds a 5% position, or only $50 million of a $1 billion company, it would have to file an SEC Schedule 13D, and when it holds a 10% position, it is subject to more stringent regulatory laws, which are restrictive and often undesirable. For a $250-million position to be only 5% of a company, when holding such a position would still require filing a 13D, the market cap of the company would have to be $5 billion.

This eliminates micro-, small-, and part of the mid-cap universe from a large hedge fund’s opportunity set. In fact, when we looked at the Goldman Sachs VIP List in the first quarter of 2015, the median market capitalization of the top 50 hedge fund holdings was $44 billion, compared with $17 billion for the S&P 500 Index. Historically, academic studies have found a correlation between market capitalization, analyst coverage, and market efficiency.

Small Managers Provide Access to More Opportunity Sets

The least-followed securities, which are historically the least covered and most inefficient and which often result in higher returns and potentially outsized track records for small hedge funds, are no longer able to be part of the opportunity set for larger, established hedge funds. In addition, these relatively smaller market capitalization securities, including portfolios of them, are often more uncorrelated or at least less correlated and, therefore, also confer diversification benefits to portfolios of larger, more established hedge funds.

Similarly, as a long-only investor, one is typically focused on investing across market capitalizations and styles, which is sensible. For example, one might want an allocation to growth, value, small-, mid-, and large-capitalization securities, often in line with index or market weightings. I believe this analog holds for hedge fund investments, which are merely a different structure (i.e., in many cases limited partnerships with the ability to short in addition to going long), and would expect such investors to want a similar allocation across the market capitalization spectrum. This is another reason that small managers complement large managers.

Small Managers Provide Access to Capacity-Constrained Opportunities

Smaller managers may also exploit opportunity sets that may be capacity constrained. For example, last year, we researched a manager with $100 million AUM that invests in exchange-traded fund (ETF) arbitrage, although not large ETFs, such as those tracking the S&P 500. The manager estimated $250 million of capacity at which it can effectively implement the strategy at high rates of return. This is a good example in that to exploit this market inefficiency, the manager must stay small and disciplined in terms of assets.

Let’s look at this in the context of the $25 billion hedge fund alluded to earlier. That would leave the entire ETF arbitrage strategy as a 1% position in such a larger fund. It is neither practical nor desirable to have a team of portfolio managers that is not scalable to only run 1% of assets. This is why a small manager, such as this ETF arbitrage example or a portfolio of them, complements larger managers.

Finally, small managers may focus on inefficiencies in highly specialized sectors and regions. For example, for the past year we have researched a $500-million equity long-short manager that is focused on the burgeoning Southeast Asian consumer, excluding the heavily followed greater China region. The manager is capacity constrained because of the smaller capitalization and relative illiquidity of its respective markets (i.e., the Philippines, Thailand, Malaysia, and Indonesia) and is able to exploit the commensurate inefficiencies in these markets that are often under-followed by the sell side and buy side.

These Additional Opportunities May Expand an Institution’s Efficient Frontiers

In summary, I tip my hat to institutional investors that have learned to appreciate the importance of investing in hedge funds that generate returns from alpha, rather than beta, and unlike long-only strategies, are not dependent on rising markets to generate returns. Institutional investors have generally accomplished this through investments in the largest established hedge fund managers.

However, I believe the next step in the evolution of these investors is to complement these hedge fund allocations with small managers who are sector or regional specialists and, in many cases, can invest in capacity-constrained strategies. Small managers complement large managers because they are inherently focused on a different opportunity set of securities. There are potential diversification, correlation, and return benefits that enable institutional investors to improve their efficient frontier (i.e., higher return with similar risk or similar return with less risk). I believe the best way to achieve these benefits is to allocate to small manager solutions providers that are best resourced to extract the alpha from this opportunity set.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Michael Oliver Weinberg, CFA

Michael Oliver Weinberg, CFA, is the Chief Investment Officer at MOV37 and Protege Partners, where he is a Senior Managing Director, and on the investment, management and risk committees. Michael is also an adjunct Associate Professor of Economics and Finance at Columbia Business School, where he teaches Pension, Sovereign and Institutional Investing, an advanced MBA course that he created. He was previously a portfolio manager and global head of equities at FRM, a multi-strategy investment solutions provider. Prior to that, Michael was a portfolio manager at Soros, the macro fund and family office, and at Credit Suisse First Boston. Before that he was a Real Estate analyst at Dean Witter. Weinberg is a board member of AIMA and on its Research Committee. He is on the management advisory council for the Michael Price Student Investment Fund and an advisory board member for the NYU Stern Investment Management and Research Society. Michael is a founder and advisory board member of YJP, a young professional organization. He is a member of The Economic Club of New York. Michael is Chair of the Value Investing Committee at NYSSA, where he has received multiple awards, including Volunteer of the Year. Michael is a published author, having written for The New York Times, Institutional Investor, CFA Institute and investment books. He has been interviewed by the Wall Street Journal, Financial Times, CNBC, Bloomberg and Reuters. Michael is a frequent panelist, moderator and lecturer for investment banks, institutional and family office organizations and business schools, including Pensions & Investments, SALT, Harvard and The London School of Economics. He has a BS from New York University and an MBA from Columbia Business School.

9 thoughts on “Small Hedge Funds Complement Large Ones”

  1. Brad Case, Ph.D., CFA, CAIA says:

    This is ridiculous. Hedge funds have been a spectacularly bad waste of money–but now you want investors to say “thank you, sir, may I have another?”
    CEM Benchmarking collected data on the actual investment returns of more than 300 large U.S. pension funds over the 14-year historical period 1998-2011, and grouped them into 12 asset classes. Hedge funds were the WORST performing asset class, with net total returns averaging just 4.77% per year: worse than all four categories of fixed income, worse than all three categories of equities, worse than all three categories of real assets. The study, sponsored by NAREIT (my employer), is available for download at
    Yet the investment costs of hedge funds averaged 125.1 basis points per year–more than for any other asset class except private equity.
    That’s the result of “the largest established hedge funds (which) are generally superior investments,” according to this article.
    So now, after institutional investors have spent 14 years paying spectacularly high costs to get spectacularly low returns, you want them to pay much HIGHER costs to get WORSE returns?
    What about the option of simply learning from past mistakes and walking away from this lousy investment approach?

    1. Jean-Charles Joachim says:

      I disagree, your conclusion might be flawed because you are looking at a specific period of time, 1998 – 2011. I believe you can always draw the conclusion that the asset class X or Z is the worst based on the period of time you are taking. I believe there are fantastic hedge funds that can deliver superior risk adjusted return, over a long period of time. All hedge funds are not that bad are you are suggesting. Please take a look at Warren Buffett, his performance has not been so great lately but since inception, his performance has been very good.

      1. Brad Case, PhD, CFA, CAIA says:

        Of course it’s true, Jean-Charles, that any short historical period may be an anomaly and that there will be variation among hedge funds just as there is variation among companies in the stock market. But the truth is that investors have been systematically unable to limit their investments to the best-performing hedge funds and/or the best-performing market periods, so that fact that a very large and sophisticated sample of investors (more than 300 large U.S. pension funds) over a very long recent historical period (14 years) realized returns that were so spectacularly bad must have some educational value. Don’t you think?
        Still, here are some other data points that should help convince you:
        (1) Dichev & Yu [2011] used data over the period 1980-2008 and found not only that “the real alpha of hedge fund investors is close to zero” but also that hedge fund returns “are reliably lower than the returns of broad-based indexes like the S&P 500 and only marginally higher than risk-free rates of return.” They concluded that “the risk-return profile of hedge fund investors is much worse than previously thought.”
        (2) Naik, Ramadorai & Stromqvist [2007] used data over the period 1995-2004 and found that “the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period.”
        (3) Griffin & Xu [2009] used data for the period 1980-2004 and found that “hedge fund holdings and trading are not adding value on average. … In terms of stock picking, there is some weak evidence that hedge funds outperform mutual funds on a value-weighted basis, but these superior returns are largely concentrated in the high price-to-sales (technology) sector in 199 and 2000. … Hedge funds exhibit no ability to rotate capital among different asset styles at opportune times and their average style selection slightly underperforms mutual funds.” Their conclusion was “Overall, we find that hedge funds seem to be no better at long-equity investment than mutual funds. Given that hedge funds generate higher turnover and trade in less liquid securities, our performance comparisons would look even worse if transaction costs were included. Back-of-the-envelope calculations using a standard hedge fund fee structure suggest that hedge funds are a worse vehicle than mutual funds over our sample period. In sum, our findings question the ability of hedge fund management to add value, particularly in the realm of long-equity investing. … We predict that as data quality improves, more studies will begin to question the wisdom of hedge fund investment.”

        1. Jean-Charles Joachim says:

          Hi Brad, yes I understand, but I believe also that part of the problem is how the allocation process is made. Money does not necessarily flows directly to the best performing funds, but rather flows to the funds that have the best marketing skills. Allocators tends to allocate money of their clients where they receive fees. If the final clients were doing there own research. Overallocation can create overcapicity problems, resulting in poor performance…

          1. Jean-Charles Joachim says:

            *I wanted to say “If the final clients were doing there own research, maybe the overall performance of hedge fund would be better than what you are suggesting”

          2. Brad Case, Ph.D., CFA, CAIA says:

            Sorry, Jean-Charles, but the argument that “this would be great if everybody simply chose the best fund” is extremely weak. If you knew which one stock would perform best, then why would you need two stocks? Why would you receive any risk premium if you were facing no risk?
            If the whole think were as simple as that–just put all your money in the best hedge fund, and don’t bother with any of the others–then wouldn’t everybody be doing that? (Unless, of course, the returns of the best hedge fund weren’t as good as the returns of the best stock–in which case no hedge funds would get any money, and no stocks other than the best one.)
            I continue to advocate thinking about the real world, not Fantasyland.

  2. Gordon Couch says:

    Hedge funds, large or small offer no or little value after fees & expenses to institutional or retail investors. They are a systematic means of transferring wealth from the investor to the manager.

    1. Brad Case, Ph.D., CFA, CAIA says:

      Exactly correct, Gordon. Thanks.

  3. MarkG says:

    I’m on your side with your belief 🙂

    “I believe the best way to achieve these benefits is to allocate to small manager solutions providers that are best resourced to extract the alpha from this opportunity set.”

    but of course he/she must have qualities 🙂

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