New research finds big hedge funds more vulnerable

Date: Friday, November 12, 2010
Author: Svea Herbst-Bayliss, Reuters

Contrary to conventional wisdom, bigger may actually not be better when it comes to investing with hedge funds.

At least that is what fund manager Jason Orchard and Fordham University accounting professor Haim Mozes found, arguing in a paper that big funds are less nimble than smaller ones and that returns will eventually lag and prompt investors to exit. The paper was released on Thursday.

"The opportunity costs of investing in large funds may be higher and the safety benefit of investing in large funds may be lower than investors currently expect," said Orchard, a principal at New York-based hedge fund Spring Mountain Capital.

Big hedge funds are more likely than smaller hedge funds to either go out of business or to restrict investors from getting all of their money back when they want, the authors wrote.

The findings stand in stark contrast to conventional wisdom that large hedge funds are better able to withstand market turmoil by hiring top analysts and having enough cash to meet investor redemptions.

Recent data from industry magazine AR illustrate investors' preference for big funds, finding that fund firms with more than $5 billion of assets saw assets climb 1 percent during the first half of 2010. Among funds with assets between $1 billion and $ billion, half said their asset levels either dropped or remained unchanged.

There are thousands of hedge funds operating around the world, but more than half of the industry's roughly $1.6 trillion in assets is managed by large funds like Bridgewater Associates, D.E. Shaw Group, Paulson & Co. and Baupost Group.

The authors describe a vicious circle where returns eventually drop off and investors realize the fund has capacity issues.

"At that point, as the fund's assets may be bid too high and it may be managing more assets under management than it is capable of effectively managing, either the fund takes excessive risk in an attempt to maintain returns or investors become disappointed and redemption requests accumulate," the authors wrote.

Indeed some of the industry's canniest managers have been known to return money to investors if they find they have grown too large and can't find new investment opportunities. This week Baupost's Seth Klarman, for example, told investors that the $23 billion fund will return 5 percent of its capital at the end of the year.

The authors said they based their findings on 7,545 still active and 8,916 shuttered funds, respectively, from 1995 through May 2010. (Reporting by Svea Herbst-Bayliss; Editing by Steve Orlofsky)