It is widely known that when too much capital chases the same idea, you can get crowding disasters like those that befell pharmaceutical company Valeant and renewable energy company SunEdison. Size is generally the enemy of all investment strategies, and a team that was adept at managing $500 million is likely to find it difficult to manage $3 billion in the same market without at least incrementally lowering the return potential of the portfolio.
Apart from the perils of trade crowding, it is simply easier to be nimble putting on and taking off trades that are smaller in size. While some large and established hedge fund managers have performed very well, smaller hedge funds have generally outperformed those with assets under management above $1 billion, as reported by HFRI.
Unfortunately, it is no secret that many managers have allowed their assets to swell well above their optimal capacity (the level at which a strategy should be capped before it hurts performance). Asset management salespeople have a tendency to push strategies that have performed well but may be capacity constrained, and they attract new assets that will further hurt capacity, thereby diluting returns. Of course, it can be a challenge to identify and access hedge funds that are not bloated with assets and have performed well, since such funds by their very nature take in new capital only selectively. But despite a generally acknowledged need for diversification within hedge fund allocations by strategy and size, many investors favor a relatively contained universe of large, established, big-name funds.
Why is that? One reason is that consultants, the gatekeepers of institutional capital, as well as advisors, often view small or niche managers as too risky to endorse. It is safer to recommend well-known and generally larger-end funds, or as the old adage goes, “You can’t get fired for buying GE.”
Another reason is the sheer size of many institutional investment plans. For instance, the California Public Employees’ Retirement System (CalPERS) had approximately $4 billion invested in hedge funds at the peak of its program, representing an allocation of less than 2% against its total portfolio of about $300 billion. As noted by CalPERS’ CIO Ted Eliopoulos when the fund wound down its hedge fund program in 2014, to make the investment meaningful CalPERS would have needed to invest at least 10%, or $30 billion. That’s simply too large an asset base to put to work in the space without incurring significant risk.
More specifically, at a 10% allocation across 15 managers, which would generally be considered a reasonable portfolio, the fund’s average allocation to each manager would be $2 billion. Using a generous rule of thumb of limiting its interest in a single hedge fund to no more than 20% of the fund’s overall assets, CalPERS would be restricted to working with managers with at least $10 billion in AUM. This example demonstrates the conundrum faced by many institutional investors—to maintain a hedge fund program of the requisite size to make an impact on overall portfolio results, without representing too large a portion of any single hedge fund manager’s capital, these investors inevitably end up with either too much diversification or with exposure to only very large managers.
While institutional investment plans can effectively become too big to allocate successfully to hedge funds, this is fortunately not the case with the average high-net-worth investor. Qualified investors should take advantage of this to look beyond the largest funds with the strongest brands, to high-performing but smaller managers and more niche strategies.
Especially in periods of low volatility, it is difficult to find much outperformance in highly efficient markets—deeper and more trafficked strategies such as large-cap U.S. equity. As noted by Ryan Nauman, market strategist at Informa, “If [you’re] really looking to add alpha or achieve outperformance over a benchmark, the asset classes that have typically offered the most outperformance over time are those with less assets that are less efficient.” Figure 1 lays out the degree to which active managers beat or underperformed each asset class’s benchmark in the last seven years (net of average fees). As the figure shows, small cap, international and emerging markets—all less efficient areas that are less easily replicated by passive strategies—have tended to outperform.
Good Things In Small Packages
June 2017
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