There is much academic and practitioner evidence suggesting that increasing assets under management negatively impacts long-only fund performance. For example, a much-quoted research paper by Jeffrey A. Busse et al concluded that larger long-only funds underperform their smaller counterparts, principally due to holding fewer smaller capitalisation stocks. From a practitioner perspective, Warren Buffett put it vividly in his 2003 Chairman’s letter to Berkshire Hathaway shareholders: “Investment managers often profit far more from piling up assets than from handling those assets well. So when one tells you that increased funds won’t hurt his investment performance, step back: his nose is about to grow.”
There are sound reasons why increasing assets might hamper performance: investment options narrow as assets increase, with larger managers limited to the most liquid investments, and less able to trade around positions. Smaller stocks offer the potential for discovering little-known ‘gems’, as they tend to be less researched by professional investors. To quote Buffett again from a 1999 Business Week interview: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I could make 50% a year.” Meanwhile, trading offers the potential of making money from the ‘journey’ as well as the ‘destination’, and can be advantageous during periods of market stress, when the ability to exit positions quickly may be particularly prized.
But do diseconomies of scale also apply to hedge funds? After all, hedge fund managers tend to make a virtue of being different and not necessarily conforming to norms. Perhaps the fee structure of hedge funds, i.e. the charging of a performance fee as well as management fees, creates the incentive for greater discipline on asset-raising compared with long-only funds that tend to only charge management fees. In addition, the studies on size and long-only fund performance tend to focus on equity funds, while hedge funds invest across asset classes. Aurum has been investing in hedge funds since 1994. Over this time, we have amassed a tremendous amount of data on the hedge fund universe. What does this data have to say on the matter? In the case of hedge funds, is size an elephant in the room or a red herring?
