There is substantial academic and practical evidence that increasing the size of assets under management can have a negative impact on the performance of pure-play long funds. For example, a well-cited research paper by Jeffrey A. Busse et al. concluded that larger pure-play long funds underperformed their smaller peers primarily by holding fewer small-cap stocks. From a practical perspective, Warren Buffett articulated this point vividly in his 2003 letter to Berkshire Hathaway shareholders:

"Investment managers profit far more from accumulating assets than from properly managing those assets. So when someone tells you that adding more money won't hurt his investment performance, take a step back: His nose is about to get longer."

It makes sense why increasing assets might hinder performance: as assets increase, investment choices narrow, larger managers are limited to the most liquid investments, and it's harder to trade flexibly on positions. Smaller stocks offer the potential to discover unknown "gems" because they are less researched by professional investors. To quote Buffett again from his 1999 interview with Business Week:

"If I were managing $1 million today, or even$10 million, I would invest it fully. The returns I made in the 1950s were the best. I beat the Dow Jones. But I had very little money invested then. Not having a lot of money is a huge structural advantage. I could make 50% a year."

At the same time, trading offers the possibility to make money from the "process" as well as the "result", especially in times of market stress, when being able to exit positions quickly may be particularly valued.

But do diseconomies of scale also apply to hedge funds? After all, hedge fund managers often view being different as a virtue, not necessarily following the norm. Perhaps the fee structure of hedge funds, which charge performance fees as well as management fees, creates greater incentives for disciplined asset raising than pure-play long funds that only charge management fees. Additionally, research on size and pure-long fund performance tends to focus on equity funds, whereas hedge funds invest across asset classes.

Growth of the Hedge Fund Industry

Before exploring the main issues, it is worth considering the growth of the hedge fund industry in recent years, particularly in relation to fund size. The number of active hedge funds more than doubled between 2010 and 2018, from about 1,700 to 3,800. Likewise, assets under management in these funds more than doubled during this period, from $1.4 trillion to$3.2 trillion.

The number of funds and assets under management are divided into five size groups: less than $50 million;$50 million to $250 million;$250 million to $1 billion;$1 billion to $5 billion; and greater than$5 billion. These groups are similar to micro-cap, small-cap, mid-cap, large-cap and mega-cap in stocks and are labeled similarly in this article.

Interestingly, while the industry has grown significantly in recent years, overall the industry has remained surprisingly stable in terms of fund size. This applies to the proportion of funds in each size group and to the assets managed by the fund. For example, considering the largest size group, funds with more than $5 billion in assets comprised 3.5% of total funds in 2010 and 3.1% in 2018, while representing an increase in assets from 41.0% in 2010 to 41.5% in 2018.

This trend is quite surprising and indeed somewhat counterintuitive. Given the significant growth across the hedge fund industry, it is not unreasonable to expect larger size groups to grow more than smaller groups. However, the size structure of the industry has remained very stable, with growth fairly even across size groups.

Size and Hedge Fund Performance

Returning to the main question of the impact of size on hedge fund performance, the chart below shows the average annual returns for the five size groups over the past nine years. While there are clear differences from year to year, the overall trend is visible: smaller funds outperformed their larger peers, with the "micro" group posting an average annual return of 7.7%, compared with 6.6% for the "small" group, 5.7% for the "mid-cap" group, 5.6% for the "large" group, and 5.1% for the "super-large" group.

While there is a clear trend, the magnitude of the difference in returns may not be as large as expected, particularly for funds with assets in excess of $250million,whichrepresentsapracticalthresholdgiventhetypicallylargerassetbaseandhigheroperatingstandardsofinstitutionalinvestors\mathrm{.}Theaver$250 million to $1 billion group relative to the >$5 billion group was relatively modest, at only 0.6% (5.7% vs. 5.1%).

Why might scale effects be less pronounced than first thought? Perhaps in the case of hedge funds, the presence of performance fees does create some discipline in asset raising. Furthermore, hedge funds' raison d'être is largely to participate in smaller, more niche markets, which may make hedge fund managers more sensitive to capacity constraints. Additionally, some larger funds are composed of multiple (in some cases hundreds) underlying portfolio managers and thus could theoretically be viewed as a collection of several smaller funds. The founder of a large, well-known multi-strategy fund likens his fund to a fleet of small, nimble ships, in contrast to a large ship that has difficulty changing course. It is also important to note that, while subject to investment diseconomies of scale, larger funds generally enjoy operational economies of scale, for example in areas such as technology and infrastructure, regulation and compliance, and financing.

Another interesting feature that emerges from the data is that the strength of the size “factor” has weakened significantly over the past three years. In fact, over this period, average annual returns across size groups were similar, with parts of the size “curve” actually inverted, with average annual returns in the mid-sized group lower than in the very-large group (3.9% versus 4.4%). Is this just a temporary anomaly, or a sign of a more permanent trend? It's too early to tell, but it's something worth monitoring and revisiting. However, it's hard to ignore the similarities in the underperformance of the small-cap factor among stocks in recent years. In fact, there may be a causal relationship, as smaller stock funds tend to have greater exposure to small-cap stocks than larger funds.

Risk

However, payoff is only half the story. What about the risks? Are there similar trends in the risk characteristics of funds of different sizes? To answer this question, we looked at volatility and beta for global stocks.

In terms of volatility, there's a clear trend: smaller funds are more volatile than their larger peers, with the "micro" group averaging 11.3% annual volatility, compared with 9.4% for the "small" group, 8.8% for the "midcap" group, 8.3% for the "large" group, and 8.0% for the "very large" group. This trend is also fairly consistent, contrasting with the weakening trend in returns. Clearly, there is a price to pay for higher volatility in order to achieve the higher returns of smaller funds.

The picture of equity betas is quite interesting: there is a "concave" relationship, with the smallest and largest funds exhibiting the highest betas, while mid-cap funds have the lowest betas. More specifically, the average annual beta for the "micro" and "very large" groups is 0.38, compared with 0.33 and 0.34 for the "small" and "large" groups, respectively, and 0.31 for the "medium" group.

Possible explanations are that smaller funds run higher market exposures because these funds have less experienced managers or because lower asset sizes provide the luxury of trading more actively and taking on greater risks. Larger funds may also operate with higher market exposure due to the difficulty of managing hedging portfolios at scale and the long-term nature of such funds. In contrast, there appears to be a sweet spot for mid-cap funds, where mid-cap managers may have matured far away from beta, but the fund is not large enough to be constrained by a larger asset base.

Return difference

While smaller funds have shown higher returns than their larger peers, what is the range of results within each size group? The chart below shows the standard deviation (as a measure of variability) of annual returns for funds across five size groups. While there are significant year-to-year differences, the overall trend is clear: Smaller funds have significantly higher return variability than larger funds, with the average standard deviation of annual returns for the "micro" group being 16.5%, compared with 13.7% for the "small" group, 11.6% for the "mid-cap" group, 10.6% for the "large" group, and 9.7% for the "very large" group. Note that the return standard deviation for the smallest group is on average 1.7 times higher than for the largest group (16.5% vs. 9.7%).

This trend is not entirely surprising: it is reasonable to assume greater differentiation among smaller funds, as smaller funds tend to be more entrepreneurial and therefore produce a wider range of results with less room for differentiation in size.

While smaller funds offer the greatest potential returns, they also carry the greatest risk, not only in terms of higher volatility and higher equity betas seen in the previous section, but also in terms of higher "execution" risk, given the greater variability in returns. Obviously, there is a greater chance of finding a "diamond" in smaller funds (similar to how equity investors tend to have more opportunity in small caps), but there is also a greater risk of hitting a "bad ball" and therefore increased reputational risk.

Summary of key results

The table below summarizes the key results of the above analysis. Note that the table includes Sharpe ratios in an attempt to combine return and volatility statistics (these are based on the return and volatility statistics previously described, using 3-month USD LIBOR as the risk-free rate over a nine-year period). Because the meaning of the Sharpe ratio expires when returns turn negative (as in 2011 and 2018), the Sharpe ratio is not presented in an annual format like other previous statistics.

While the Sharpe ratio trends downward as assets increase, this trend is not uniform, and the results suggest that investors who want to maximize the Sharpe ratio may want to target funds with assets between $50 million and$250 million.

Conclusion

Hedge fund managers may pride themselves on being different, but at least in terms of size, they are not immune to the well-known diseconomies of scale of their pure-long counterparts. Still, the impact of size on returns is not as large as one might expect, especially for funds with assets above $250 million, which is a practical threshold for many institutional allocators. Also worth noting is the clear weakening of the size factor over the past three years. Additionally, while smaller funds offer the greatest potential returns, they also carry greater risks, including higher volatility, equity beta, and return variability. For allocators willing and able to move down the scale curve, there are potential rewards, but also greater execution and reputational risks. Therefore, a robust investment and operational due diligence process becomes even more critical when considering smaller funds.

In other words, every hedge fund is unique, so each needs to be considered on its own merits, taking into account a variety of factors, both general and specific. However, size is clearly a factor that cannot be ignored. Because, while perhaps more of an echidna than an elephant in the room, size is a factor that hedge fund investors would be wise to weigh carefully in their investment allocation decisions.

Further research

Do size factors differ between hedge fund strategies? It is reasonable to assume that some strategies are more sensitive to asset growth, such as those associated with less liquid assets, high leverage, or high turnover. For highly leveraged fixed income relative value funds and high turnover statistical arbitrage funds, do returns decline faster as assets increase? In contrast, strategies tied to more liquid assets, such as global macro and CTAs, may be less sensitive to asset growth. In the case of multi-strategy funds, there may even be an inverse relationship, given that operating economies of scale are particularly important for such funds. Further work is needed to dig deeper into the data and study these relationships.

Another area worthy of further research is the relationship between fund age and performance. Does the "young gun's" desire to succeed provide an advantage, or is it the experience of the "old hands" that really matters? Since smaller funds tend to be newer, perhaps age rather than size is the real differentiator in performance!

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