Is Bigger Better? Hedge Funds Get Bigger, Returns Get Smaller

Fast food? Supersize it. Coffee? Get it by the gallon. Real Estate? Better go with all the features, “so at least you’ll have them.” Getting more is something that’s been engrained in our consumer minds. However, when it comes to the world of investing, bigger might not always be better. In other words, choosing a larger, actively managed fund over the broad stock market doesn’t necessarily mean you’ll walk away richer. Are Mega Hedge Funds the Way?

While putting your money into a large hedge fund, like well-known Anchorage or Bridgewater, might seem at first glance like the best way to capitalize on market-beating returns, research has long indicated that earnings fall as the size of a fund increases. Why does this happen? For decades, economists have studied the diminishing effects of alpha as funds grow in size, but have reached conflicting conclusions. Hedge funds are hard to study due to their lack of data. Some experts think investors can beat the market with active management, while others believe it’s merely a statistical trend.

In a recent paper released last month by Campbell Harvey of Duke University and Yan Liu of Texas A&M University, this concept was brought to light once more. The research from these two academics found a “significant negative relation between fund size and performance.” If alpha does not rise as funds increase, then the fund experiences a lower return.

Understanding Decreasing Returns of Scale  

Let’s take a look at the stock market for an example.

Imagine you have $1 million to invest in the stock market. You leave it there for 10 years with an annual return of 10 percent. With the power of compound interest, your money will continue to grow at a steady rate over time. At the end of 10 years, you are 2.5 times richer than when you started. This is because the interest you earn on your stocks will get reinvested, thus earning more interest on top of the principal sum. Historically, compound interest causes a ballooning effect that yields returns over a long period of time. The whole “sit and wait” strategy is usually seen as one of the safest ways to grow your money, at least on the stock market.

Now, let’s take the same $1 million in this example and invest it into a hedge fund. Let’s say the fund has an annualized return of 25 percent. On the surface, it looks like this investment would yield huge results year-after-year. However, hedge funds can only manage a certain amount of assets. In order to stay within their limit, they pay out profits each year to investors. The interest would be paid out to you instead of being left to compound, which would then lower your yearly returns.

Distributing the profits keeps the fund’s managed assets down and allows alpha to stay higher, but doesn’t give the benefits of compounding interest that you find in the stock market. Another theory that drives down returns, has to do with price impact. Managers who move around large sums of money, risk driving down the price of commodities. This is another reason why they want to keep their accounts capped at a certain amount, say $1 billion in assets. Anything above that amount could drive down alpha further and stir up the market during trades.

Do Hedge Funds Risk Getting So Big That Their Returns Diminish?

The idea of decreasing returns of scale would indicate that it’s a good possibility. Before you reach for all of the bells and whistles of a growing hedge fund, you might want to consider that bigger might not always be better.

InvestingThomas J. Powell