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Smaller Hedge Funds Can Outperform Bigger Ones

Size and age matter, according to a new hedge fund study which reports that smaller and younger hedge funds produce better returns than larger ones. But it's a little more complex than that.

  • By Stephen Taub

The smaller or younger a hedge fund, the better it performs. That’s the conclusion of a new, comprehensive study from PerTrac, which performs analysis of hedge funds and other investors.

For example, the study found that in 2010 young funds — defined as those two years old or less — outperformed midage funds (two to four years old) and tenured funds (older than four years). They returned 13.25 percent, 12.65 percent and 11.77, respectively.

That is no one-year trend. PerTrac went back to 1996 and found that young funds beat the two older groups in 13 of the 15 years. During that period the annualized compound rate of return was 16.18 percent for young funds, 12.20 percent for midage funds and 10.92 percent for tenured funds.

In 2010 tenured funds accounted for 53.13 percent of all hedge funds, compared with 22.44 percent for midage funds and 24.43 for the youngest group.

A similar performance pattern has played out for the smallest funds, defined as having less than $100 million, compared with midsize funds ($100 million to $500 million) and large funds (more than $500 million).

For example, in 2010 small funds returned 13.04 percent, compared with 11.14 percent for midsize funds and 10.99 percent for the largest funds.

In 2010 small funds represented 71.39 percent of the hedge fund universe, midsize funds 21.17 percent and large funds 7.44 percent.

So does this mean investors should rush out and buy puny new hedge funds? Not so fast.

First of all, be mindful of the study’s definitions. Large funds, for example, are defined as having more than $500 million. I personally still perceive a $500 million fund as being somewhere on the upper range of small. Other people consider it to be midsize.

In a survey earlier this year, Citigroup defined a midsize hedge fund as having between $1 billion and $5 billion. That’s in line with how I think of the industry.

Okay, now that we have resolved the definitional dilemma, let’s drill down to the heart of the PerTrac study.

The data found that the smallest and youngest funds — which I suspect are frequently the same funds — outperformed their older and bigger brethren.

I don’t dispute the data. However, what the study does not examine is what happens when the two-year-old fund ages to three, four or five years, or when the little $100 million fund starts scooping up wads of money because investors are impressed with its initial strong performance.

My anecdotal observation after following hedge funds for 25 years: Many of these funds eventually blow up or suffer big declines. Frequently, very small funds are able to build very strong early performance if just one or two stocks in their portfolio get hot. This no longer happens when the fund grows larger and one or two investments play a smaller role in the overall portfolio. Ideas No. 15 through No. 25 rarely do as well as a manager’s top ideas, let alone positions 80 through 100.

Even the top-performing hedge funds of all time enjoyed their best years during their earliest days. For example, Paul Tudor Jones II first made a name for himself in 1987 when he called the fall market crash and rode a heavy short position in stock index futures to a 201 percent gain for the year. He was up close to 90 percent in 1990. But he hasn’t come close to those types of returns since then, as his Tudor BVI fund has grown to $8 billion.

Bruce Kovner racked up nearly triple-digit returns in 1987 as well.

Of course, these examples would would strengthen the study’s conclusion that investors should focus only on small funds and shun funds once they become larger or older. In other words, dump the fund after two years or $100 million.

Not a good idea.

It would require investors to deftly pick the next hot fund at least every two years, if not more frequently if they own a portfolio of funds. This is not an easy task. Many new funds quietly close down without ever reporting their performance, so we never even know they existed.

Even the PerTrac study underscores the riskiness of investing in these lesser-known funds. It found that small funds have produced better returns, but with more volatility. Since 1996 the annualized standard deviation for small funds is 6.95 percent, midsize 5.94 percent and large 5.96 percent.

Another warning: Funds with less than $150 million in assets are exempt from the registration requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Buyers of small funds, beware.

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