As funds of hedge funds continue to refine their value proposition in the wake of the Madoff fiasco, more and more discussion seems to focus on the critical role of funds of funds in aggregating and delivering niche sources of alpha. Some researchers have gone as far as to attach a sociological significance to FoF’s intermediation role between end investors and idiosyncratic hedge fund managers (see post). Fewer funds of funds, the argument goes, means fewer creative single managers.
There’s now a large body of research that suggests smaller managers do, in fact, deliver higher returns than large ones – even when the usually database biases are neutralized. However, as we reported early last year, 2008 provided a notable exception. That year, a study by data provider Pertrac found that smaller funds performed worse than large ones.
In this year’s report (released in September), Pertrac found that the universe was returning to normal, sort of. As the chart below form the report shows, small funds did indeed beat large funds last year. But for the first time since 1996, medium-sized funds (those with $100 million to $500 million in assets) posted higher returns than either small or large funds.
Medium-sized funds have often trailed smaller funds in the past and have even been a bit of a goat compared to both small and large funds. It’s as if $100m-$500m was the anti-sweet spot of hedge fund management. But not in 2009!
Pertrac suggests that one reason may have been an increased administrative and regulatory burden placed on managers after the debacle of 2008. Assuming that the costs associated with this burden were borne by the manager, not the fund, the link between burden and return is indirect at best.
Another possible reason, they say, was that there was a flight to quality (read: large funds) in 2009. But mid-sized funds still beat large funds. So we’re guessing the flight could not have been fully booked.
A third possible reason for the out-performance of mid-sized funds over smaller ones was simply that there was a “reclassification of funds” as poorly performing large funds cascaded down to “mid-sized” and then to “small.” As the firm hypothesizes:
“After several months of this cycle, the worst-performing large funds would become mid-size funds and the worst-performing mid-size funds would become small funds. Thus, over time, the small fund index would collect more and more of the “loser” funds, bringing its performance down while leaving the mid-size index with a higher percentage of performing funds.”
Alas, as Pertrac acknowledges, this doesn’t explain why the mid-sized group – replete with losers from the large category – outperforms large funds. We also note that this dynamic does not appear to have played out in the past. So why now?
Age-ism in Hedgistan
Regular readers may remember this post about a study comparing the overlapping effects of fund size and fund age on returns. Of course, age and size often both conspire to effect performance. For that reason Pertrac also analyzed funds based on their age. They found that although small funds had an anomalous underperformance in 2008, young funds actually blew away middle aged and “tenured” funds (kudos to Pertrac for being politically correct here). As the chart below from their paper shows, “tenured” funds matched the young guns for the first time since 2003.
Still, over the last 15 years, young funds have posted a compounded rate of return of over 16% while their silver-haired mentors have only managed to post a 10.78% compounded annual return (with about the same standard deviation). It would appear that age is more important than size.