The Elusive Small Fund Premium

Interest in Small and New Hedge Funds and Mutual Funds

There has been a continuous interest by investors in small and emerging hedge funds because of a widely cited assumption that these funds provide a better performance than older and larger funds. A number of studies have pointed to a performance advantage enjoyed by smaller and newer funds. This interest is shown by the number of funds that have been formed that invest or seed new funds.

Various reasons are provided for this perceived outperformance, including the observation by David F. Swensen, Yale University Endowment’s CIO, that “Attractive investment management organizations encourage decisions directed toward creating investment returns, not toward generating fee income for the manager. Such principal-oriented advisers tend to be small, entrepreneurial, and independent. (Pioneering Portfolio Management). A similar argument has also been made for mutual funds. An article titled “Scale and Skill in Active Management” (NBER Working Paper No. 19891) by Lubos Pastor, Robert Stambaugh, and Lucian Taylor finds that: “Trends suggest that new active funds entering the industry are more skilled, on average, than the existing active funds. As a result, younger funds outperform older funds in a typical month. Indeed, funds up to three years old outperformed funds ten years and older by 0.9 percent a year. Funds aged between three and six years also outperformed the oldest funds.” (New funds are smaller than older funds so age can be substituted for size).

Some Problems with the Small Fund “Advantage”

Operationalizing the Small Fund Advantage

In my book, “All about Hedge Funds, Second Edition” (by Ezra Zask; McGraw Hill; 2013) www.allabouthedgefunds.com) I pointed out the virtual impossibility of operationalizing the small fund advantage. Even if this advantage exists in the aggregate, how does an investor reap the benefits? There are thousands of small, new and/or emerging hedge funds. By definition, they have short performance records, few customers and small amount of assets under management, which reduces potential interest from large institutional investors; the source of most of hedge fund assets. These traits also make due diligence exceedingly difficult, expensive and time-consuming.

Most importantly, it is impossible to invest in a security or vehicle that would provide the returns of "small size" in aggregate of even a reasonable subset of funds that would mimic the return advantage. Thus, investors have to rely on their ability to identify the small number of small funds out of thousands that will actually produce desirable returns over a sustained period of time. Given the documented failure of investors to identify large funds that will yield future outperformance, it is highly unlikely they will do so with smaller funds, whose performance is susceptible to large swings as they grow in size.

Recent Study Questions the Small Fund “Advantage"

An April 2014 article by eVestment Research Division, "Impact of Size and Age on Hedge Fund Performance: 2003 -2013" tests the hypothesis that small and new funds outperform larger and older funds. The study finds that If any small hedge funds have been the industry’s best performers on a cumulative basis since 2003, However much of this is due to periods of outsized returns and often by funds with the lowest AUMs, an indication that replicating this outperformance would have proven virtually impossible. Age appears to play a greater factor in relative performance than size. Young funds posted the highest cumulative return since 2003 and during the past five years have also outperformed mid-age and tenured funds.”