| Size is not everything as biggest and smallest FOHFs underperform |
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| 25/11/2007 | |
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Top-sized and smaller fund of-hedge-funds (FOHF) tend to under-perform their midsize counterparts. The smallest 25% of FOHFs underperformed the largest 75% of funds by more than 2% annually, but the largest 5%. FOHFs also underperformed the rest of a study universe between January 1996 and November 2006, according to Ibbotson Associates. "For mutual funds, the literature demonstrates that the best-performing funds receive significantly higher capital flows," notes the Ibbotson study. "In contrast, the results are mixed on the performance-flow pattern for hedge funds." The underperformance of the smallest funds is not due to risk exposures or significantly higher management fees but because there is a higher portion of failed funds in the group which on average delivered lower alpha than larger funds. Capacity constraints Meanwhile, above average flows into top-performing and top-sized funds result in capacity constraints, which often hurt future performance. On the other hand, top-sized funds with below average asset flows performed significantly better than top funds with above average flows. "The largest 10% of funds with above-median capital inflows under-performed the largest 10% of funds with below-median capital inflows," according to the study, "while the remaining 90% of funds with above-median capital inflows are indistinguishable from the other 90% of funds with below-median capital inflows." Therefore, a higher flow into smaller-sized funds has no significant impact on performance. The data was culled from the TASS and Morningstar hedge fund databases. The researchers made use of defunct FOHFs to mitigate the impact of survivorship bias. The sample universe includes 4,312 funds of which 1,802 are defunct. In January 1995, the smallest fund in the sample had $200,000 in assets under management while the largest fund had $1.95bn. Nearly twelve years later, the smallest fund in the sample had $104,000 in assets compared to $80.8bn for the largest. Is it possible that smaller funds have a higher cost structure which impacts their returns? The difference in management fees charged by the smallest 25% of FOHFs and the biggest is only 0.13% and therefore incapable of explaining an underperformance of more than 2%. "The underperformance of smaller funds reported may be attributed either to a systematic difference in investment skill among managers of different size portfolios or unlucky risk exposures," concludes the report. VB |
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