In this article, we'll look at how dollar return is affected by hedge fund AUM, and the implications for institutional investors.
It’s important for endowments and foundations (E&Fs) to analyze how they invest in managers based not only on percentage returns but also on dollar returns. Doing so allows a wider range of analysis on the success of the institution—whether you’re mitigating expenses or reinforcing capital growth. In our recent article, we identified a trend when examining the average return across small-to-large-sized managers. In the piece, we showed that the lower the assets under management (AUM) the higher the returns, and as managers moved up the AUM spectrum, the return percentage decreases.
Intuitively, this makes sense. As managers grow their capital base it’s more difficult to create outsized returns. We usually refer to this as capacity constraint. Smaller managers’ singular ideas can drive high percentage returns while large managers must continue diversifying their returns, spreading them across many ideas. This has major implications for E&Fs who want those higher returns, but need to know how much actual cash is being realized.
Creating a Dollar Return by AUM Decile
In order to create a dollar return, we have to make a few assumptions. We’ll take the previous year-end reported market value as the fund’s beginning-of-year AUM. Multiplying that by the actual year-end return and assuming there are no inflows or outflows gives us the dollar return. We then average the dollar return across the AUM deciles irrespective of year. The result is an average dollar return in each AUM decile.
This average dollar return shown below exhibits an upward trend toward larger managers. While they’re generating smaller returns on their assets than lower AUM funds, the average dollar return is higher due to the higher capital base.
The difference is drastic but expected. The returns on a percentage basis in fig. 1 show the 80th and 90th decile percentiles are ~100bps lower than their counterparts, but the difference in dollar terms in fig. 2 is >3x. If you earn 1% on $500MM, you make $5M, but if you earn 1% on $5B then you make $50MM. This doesn’t mean small managers aren’t good investments, but E&Fs need to consider the dollar return implications if relying on a steady cash flow.
Let’s remove the largest managers in the top decile that are over $4B in assets. There are three apparent buckets: below the 40th percentile, above the 40th but below the 70th and above the 70th percentile.
This breakdown roughly corresponds to AUM buckets of under $500MM, $500MM to $1B and above $1B. Obviously, a small manager and a large manager will generate different dollar returns. To get around this, an investor can construct a portfolio of small managers that generate the same dollar return as a large manager.
Small Managers – Actual vs. Equal Weighted Comparison
Comparing the actual performance of these smaller managers to an equally-weighted portfolio gives us insight into the small managers’ ability to size positions, revealing their skill in generating returns through active management. When examining the aggregate data it’s important to note that smaller managers are typically younger with shorter track records and may have high short term returns that diminish over time. That being said, analyzing the data in aggregate provides insight into the process of investing in smaller managers and leads to better questions around portfolio construction.
Larger managers tend to have higher standard deviations, or risk, than their smaller counterparts when comparing their actual portfolios to an equally-weighted portfolio. Managers between the 20th and 40th percentiles, those under $500M bucket, have lower standard deviations, implying that their position sizing decisions have helped diminish risk in their portfolios.
This also appears when examining the drawdown differences, but extends to funds below $1B (under the 70th percentile).
Finally, comparing the sharpe ratios (risk-adjusted returns) reveals that managers from the 30th to 50th percentiles (roughly $250MM to $500MM), and those above $800MM offer a better average sharpe ratio than an equally-weighted portfolio.
As an investor that needs cash to pay for the expenses or investments of a foundation or university, allocating to smaller managers means allocating to multiple managers. Based on the aggregate data above there are many ways to find small managers skilled in reducing their risk through position sizing and delivering risk-adjusted returns. If we construct a portfolio of three managers, two under $500M, and one between $500 and $1B, it could have a reduced standard deviation, lower drawdowns, and a higher sharpe ratio. This hypothetical portfolio could not only generate a similar dollar return to a larger manager, but also a higher-quality return from active management decisions.
It’s important to note that smaller managers can have a greater degree of risk than larger managers, particularly single-position risk. This is another reason to construct a diversified portfolio of small managers to reduce those single name risks from each manager. An investor should also request position-level transparency from these younger and smaller managers to ensure their active management skills generated their returns.
Smaller managers are an important part of investor’s portfolio for generating diversified returns, and identifying trends along the AUM spectrum offers insight into new opportunities. Constructing a portfolio of smaller managers requires identifying managers that can prove their skill sets. Building a portfolio should not simply use returns to identify areas of diversification. The Novus platform allows an investor to build a portfolio with diverse skill sets and discover smaller managers good at picking stocks, sizing positions, trading their portfolio, allocating risk, and managing exposures with the swings of the market. When investing in smaller managers, identifying potential areas of diversification that can reduce risk and generate returns through skill can help E&Fs ensure they are generating the returns needed to fund their missions.