Investment managers have struggled for years to find unexploited market anomalies that may be able to generate alpha. Extensive research has indicated that there is a positive relationship between the relative size of a fund and its performance: smaller funds outperform larger funds. The industry has rushed to invest in small funds to capture this alleged out-performance. Large asset management companies, banks, hedge fund manager and even pension funds have raised assets to invest (or to take equity stakes) in small funds on the assumption that they will provide better risk-adjusted returns than their larger siblings.
Various explanations have been given for this supposed small fund outperformance. For example, David F. Swensen, Yale University Endowment’s Chief Investment Officer, claims that 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 in favor of small funds has also been made for mutual funds mutual funds in an article titled “Scale and Skill in Active Management” (NBER Working Paper No. 19891) by Lubos Pastor, Robert Stambaugh, and Lucian Taylor) which 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.”
However, in practice it has been extremely difficult to profit from this anomaly, leading to the closure of some investment funds.
In my book, “All about Hedge Funds, Second Edition” (by Ezra Zask; McGraw Hill; 2013) I pointed out the impossibility of operationalizing the small fund advantage. (www.ezrazask.com) Even if this advantage exists in the aggregate, how does an investor reap the benefits? Here are the problem.
First, what exactly do you invest in? There are thousands of small, new and/or emerging hedge funds and mutual funds. Each year, several hundred new funds are launched. In other words, here is no shortage of small funds to choose from. However, there is no investable index for small funds. By definition, many have short performance records making comparison between funds difficult or impossible. Also, small funds are more likely to close up shop than larger funds, which makes any index highly unstable. Which leads to problem of operationalizing the small fund investment.
To profit from the small fund advantage, an investor will have to pick a workable number of "winners" from a pool of thousands of funds: i.e., the funds that will outperform and remain solvent. Manager selection is extremely difficult for large funds, and I would argue nearly impossible for small funds. Choosing the winning fund(s) would be comparable to investing in Microsoft when it was launched. (As! If only...)
In addition, small funds have short performance records, few customers and small amount of assets under management, precluding investments by larger funds; notably mutual funds. This makes due diligence, which typically call for three years of performance, a real problem. Further, their investment strategies may change over time as they receive additional funds and learn from the market.
I have not yet come across a methodology for taking advantage of the elusive small fund advantage. I would love to hear from anyone who knows of such an animal.
About Ezra Zask
Ezra Zask has spent over 30 years in the finance and investment areas, providing research and consulting to investors and investment management companies. He has founded and managed a hedge fund, fund of funds and investment advisory firms, ans held senior positions in hedge funds and investment advisory firms. He has taught at Princeton and Yale graduate schools and written extensively including a best-selling book, All About Hedge Funds, Second Edition (McGraw Hill: 2013)