In recent years, there has been much discussion as to the optimal size of a hedge fund, and whether smaller hedge funds achieve higher returns than their larger counterparts. The industry saw net investor inflows of $44bn in 2017, driving total assets under management (AUM) to $3.58tn. According to the 2018 Preqin Global Hedge Fund Report, the largest proportion (52%) of vehicles that recorded capital inflows in 2017 had AUM of between $500mn and $999mn. In contrast, 57% of the largest funds (those with assets amounting to $1bn or more) saw outflows. This preference for mid-sized hedge funds has prompted an examination of the underlying relationship between AUM and returns posted in 2017 and over the longer term.
According to Preqin’s online platform, the majority (61%) of hedge funds have AUM of less than $100mn. Funds with $100-499mn in AUM account for a quarter of all funds tracked by Preqin, and those with $500-999mn and $1bn or more make up 6% and 7%, respectively.
2017 saw the highest return (+11.41%) generated by the hedge fund industry since 2013. Preqin data demonstrated that funds with $100-499mn in AUM achieved the highest cumulative return in 2017 at 11.91%, while vehicles with AUM of $1bn or more trailed their counterparts, posting the lowest return of 8.04%.
The chart below highlights the annualized hedge fund performance over five-year periods according to the 25th percentile, median and 75th percentile values. In terms of dispersion, funds exhibit less variation as AUM increases. The smallest funds (less than $100mn) saw a difference of 8.01% between the 75th percentile and the 25th percentile values, while the largest funds witnessed a dispersion of 6.05%. The 75th percentile of funds with $100-499mn in assets achieved the largest return of 10.70%, with the top 25% of funds achieving an average return of 15.22%.
A common metric used for hedge fund performance is the Sharpe ratio, a measure of risk/return trade-off that allows for standardized comparisons between funds with different volatilities. Investors generally prefer a higher Sharpe ratio as it represents a higher return earned from each additional unit of volatility. Funds in the $500-999mn category have the highest average Sharpe ratio at 1.22, while those with less than $100mn generated the lowest average Sharpe ratio at 0.66.
The returns across the fund size spectrum underline the advantages and difficulties faced by hedge funds of different sizes. Smaller funds are more nimble and flexible in their investment strategies, which can lead to high returns as managers seek so far unexploited opportunities. However, many also carry risks of business and operational failures, and face challenges in securing and retaining capital, which may lead to underperformance.
At the other end of the size spectrum, large funds are more established in their businesses and receive greater recognition from investors. However, they may not be able to take advantage of niche and newly identified markets as quickly as smaller funds due to their sheer size. Furthermore, as assets grow, management fees form a more significant portion of a manager’s income, which may incentivize risk-averse behaviour to protect revenue streams. Therefore, fund size remains an important factor which hedge fund managers should consider as it could potentially limit a fund’s upside potential.