Large Managers Get the Money, but Small Managers Provide the Performance

Small hedge funds are beating their larger brethren by a record margin, according to PivotalPath.

Illustration by II

Illustration by II

Investors, faced with having to do due diligence remotely, have been sending the lion’s share of any new money to the large diversified asset managers that they already know. But it’s the smaller hedge fund managers that are providing the best returns, according to new research.

Hedge fund managers with assets of less than $100 million on average generated returns of 10.6 percent year to date through August, according to research firm PivotalPath. Managers on the opposite side of the spectrum, those with more than $5 billion, returned 1.3 percent year to date.

“That’s as extreme as we’ve seen it since we’ve been looking at the data this way,” said Jon Caplis, CEO of PivotalPath, in an interview. “It’s so monotonic. The larger you are the worse you do. The smaller you are, the better. It’s never that clear.”

The pattern of large versus small repeated itself for other categories of sizes. Managers with between $250 million and $500 million returned on average 10 percent year to date; those with assets between $500 million and $1 billion returned 5.8 percent. Firms with assets in the range of $1 billion to $2.5 billion had returns of 3.8 percent and those with $2.5 to $5 billion had returns of 2.2 percent, according to PivotalPath.

“Money flowing to managers that are so large means that their approach will be more beta than anything else, and their returns will be restricted,” said Caplis. “Smaller managers will get smaller and smaller on a relative basis, but they’ll be able to generate unique performance and do interesting things in risk premia, global macro, quant. The bigger guys can’t do it, but they can raise more capital.”

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While PivotalPath covers hedge funds, studies show that smaller traditional managers also outperform larger firms. In addition, even managers that not everyone would consider small beat mega-size organizations.

Money managers with less than $100 billion annually generated 62 basis points above their larger peers, on average, according to a 2018 Affiliated Managers Group study. Boutiques beat relevant indexes by 135 basis points annually between 1998 and 2018, the study found.

Over 20 years that meant investors who solely allocated to boutiques would have 16 percent more wealth than if they had hired mega-managers. An April update to the study found that smaller asset managers, owned by their partners, significantly outperformed their larger, non-boutique peers as well as indexing strategies during periods of high volatility. The study examined independent boutique performance in volatile market environments over the past 20 years.

Stephen Prince, head of TFG Asset Management and a member of the investment committee and risk committee of Tetragon’s investment manager, agrees with the research, with a few exceptions.

“Certain strategies that are capacity-constrained benefit from being kept small,” he said. “But others, such as quant or distressed, benefit from scale and larger research budgets, for example. We want to size our businesses to make sure that we’re not amortizing the same amount of alpha over more and more assets.”

He pointed to Mike Humphries, who runs convertible securities, as an example of someone who has grown his convertible strategy slowly and deliberately.

“Conversely, we thought the strategy that Sonny [Kalsi] and John [Carrafiell] at real estate firm GreenOak had around growing their platform by merging it into Sun Life’s Bentall Kennedy business was the right approach for that business and for its investors,” her said.

The combined business, called BentallGreenOak, now has $49 billion in assets. TFG Asset Management owns minority and majority private equity stakes in asset managers.PivotalPath’s Caplis explained that there will come a time when investors realize they’re missing out on better returns just because they’re going with who they know. At that point, smaller managers will be able to show a track record of significant outperformance.

“Now they may feel they have a fiduciary obligation to only know invest in managers that they know. But then at some point, that logic will flip that and they’ll say, ‘but I’m missing out on all these other opportunities, only because I can’t do the due diligence.’ That’s going to open world for smaller managers,” he said.