Does Size Matter in the Hedge Fund Industry?
Size does matter, but not in the way you're thinking. A common belief is that larger managers underperform smaller managers. Is it true?
The million—or billion—dollar questions:
- For managers: How do you navigate growth: are you an alpha generator or an asset gatherer?
- For investors: Do you believe smaller managers perform better than larger managers? Is this one of your core marketing and investing strategies?
It’s a common belief in the financial sector that larger active managers underperform smaller managers. When AUM growth is linked to style drift that forces managers out of their area of expertise, it could translate into lower returns. One of the style drifts we commonly see among our public managers is a shift in the average Market Cap as AUM increases. It correlates to broad swaths of market theory that says inefficiencies (alpha opportunities) are riper in smaller capitalization companies because they are less covered and thus less efficient.
One could argue, then, that as managers are forced to ramp up their market cap exposure because of an increase in AUM, this may have a negative spillover effect on alpha generation.
We are going to show that the connection between market cap investing and performance is not as tight as many in the financial sector believe. For that, we will analyze:
- Weighted Market Cap exposure: in what market caps have managers (of different Market Value buckets) been investing in the last 10 years?
- Alpha performance: how have managers of different market value buckets perform over time?
About our Data
Everything mentioned in this post is sourced exclusively from public regulatory data, including the manager’s profile, simulated performance, and all other analysis and commentary. The data used here omits the short side, non-equity securities, many non-US securities and all non-public information such as actual fund performance.
Investing in Different Market Caps
The first assumption to tackle is whether smaller managers invest in smaller companies, where they presumably have access to more alpha opportunities. But what does the data say?
We have divided the ~1150 managers of our Hedge Fund Universe (HFU) into four Market Value buckets: $100-300MM, $300MM-1B, $1-3B and >$3B. These represent the reported assets under management of the underlying funds. We then calculated the average of the Weighted Market Cap per year of these funds’ underlying investments. The results are as follows:
Since 2008, all of the manager groups have increased the weighted market cap of their underlying investments by at least 55%. There are two main observations we can draw from the above graph: 1. while historically smaller managers have invested on average in smaller companies, that trend has been reversing since 2013; and 2. across all Market Value ranges, the average of the weighted market cap per range is a large-cap company.
The above destroys the first of the arguments: across all the Hedge Fund Universe, it cannot be said that an increase in Market Value will necessarily lead into an increase in the average of the Weighted Market Cap.
Alpha by Market Value
Before looking into the numbers, it’s essential to clarify that our main data source is the SEC filings of managers with a reported market value of $100MM or above. These filings mainly capture long positions, so our analysis is limited to the alpha generation of the long book across the four selected Market Value ranges. Managers with smaller asset bases (i.e., <$100mm) may be more smaller cap intensive, but we have no insight into this sleeve of managers.
When we then look at alpha by these sleeves of managers, the results are surprising: in the last 10 years, with the exception of 2009 and 2010, smaller managers have generated less alpha in comparison to bigger managers.
Managers reporting >$1B of market value from the long side have performed better overall during this time frame.
This destroys the second of the arguments: smaller managers do not necessarily outperform bigger managers.
What’s the Explanation?
Although some strands of academic literature support our findings, there are several potential explanations for our results, among others:
- We are capturing long positions for the most part. Smaller managers may have better opportunities in the short side, which would not be accounted for in the above results.
- Managers with Market Value less than $100MM may perform better than all other Market Value ranges but are absent from this study.
- Other non-equity strategies may be more suitable for smaller managers. The mandatory SEC disclosures capture most equity and equity-like instruments, but not all security types.
- There may be other style drifts that explain better historical performance.
As always, before investing in a new manager one should look into a broad spectrum of metrics and factors. In this article we try to demystify a common belief in the financial markets: smaller managers do not always outperform bigger managers, at least in the long book.