Small, New Fund “Advantage” Difficult to Exploit as Evidenced by Failure of Hedge Funds Headed by Former Goldman Sachs Traders

KKR’s recent closing of a hedge fund launched with pedigreed management and strong KKR backing points to the extreme difficulty of operationalizing the oft-mentioned advantage that smaller and newer funds have over larger and more established funds. This is one of a number of funds started by former Goldman Sachs traders which have since closed. However, if any funds belongs in a portfolio of smaller and newer funds, it would likely include those headed by former Goldman Sachs traders, long considered among the best on Wall Street. Continued Interest in Small, New, Emerging Hedge Funds and Mutual Funds There has been a continuous interest in small and emerging hedge funds based on the assumption that these funds have a better performance than older and larger funds. A number of studies have pointed to a performance advantage enjoyed by smaller and newer funds over their larger and more established peers. This interest is shown by the number of funds that have been formed that invest or seed new funds, including funds started by CalPERS. Various reasons are provided for this perceived difference, including the observation by David F. Swensen, Yale University Endowment’s CIO, that “Attractive investment management organizations encourage decisions directed toward creating investment returns, not toward generating fee income for the manager. Such principal-oriented advisers tend to be small, entrepreneurial, and independent. (Pioneering Portfolio Management). A similar argument in favor of small funds has also been made in the case of mutual funds, most recently in an article titled “Scale and Skill in Active Management” (NBER Working Paper No. 19891) by Lubos PastorRobert Stambaugh, and Lucian Taylor which finds that: “Trends suggest that new active funds entering the industry are more skilled, on average, than the existing active funds. As a result, younger funds outperform older funds in a typical month. Indeed, funds up to three years old outperformed funds ten years and older by 0.9 percent a year. Funds aged between three and six years also outperformed the oldest funds.” Some Problems with the Small Fund “Advantage” Operationalizing the Advantage In my book, “All about Hedge Funds, Second Edition” (by Ezra Zask; McGraw Hill; 2013) I pointed out the impossibility of operationalizing the small fund advantage. (See www.allabouthedgefunds.com) Even if this advantage is valid in the aggregate, how does an investor reap the benefits? By any criteria, there are thousands of small, new and/or emerging hedge funds. By definition, they have short performance records, few customers and small amount of assets under management. The latter eliminates potential interest from large institutional investors, where most of the hedge fund money comes from. The former makes due diligence and references exceedingly difficult. Finally, there is no way to invest in all the funds or even a reasonable subset or index. As a result, an investor needs to rely on their ability to identify the few new funds out of thousands that will actually produce desirable returns. Recent Studies Question the Small Fund “Advantage" An April 2014 article by eVestment Research Division, Impact of Size and Age on Hedge Fund Performance: 2003 -2013 looks to test the hypothesis that small and new funds outperform larger and older funds. The study concludes that, while the advantage may have existed in the past, it has not been evident over the past several years. If any advantage exists, it belongs to new hedge funds. “Small hedge funds have been the industry’s best performers on a cumulative basis since 2003, however much of this is due to target periods of outsized returns and often by funds with the lowest AUMs, an indication that replicating this outperformance would have proven difficult. More recent data shows the tendency for smaller funds to outperform has declined. During the last 5 years, small funds trailed the medium and large funds on a cumulative basis. By annual returns, the dominant annual performance streak of small funds decreased in 2009 and has been inconsistent since. Age appears to play a greater factor in relative performance than size. Young funds posted the highest cumulative return since 2003 and during the past five years have also outperformed mid-age and tenured funds.”