CLP Strategies, LLC

Hedge Funds: Size is the Enemy of Returns

As the 20-year surge in hedge funds begins to decline, some say the asset class has lost its focus.Hedge funds are too big and too generic. That has led, in part, to the industry’s current reputational challenges, including widespread criticism for poor performance.

At a meeting last week of the family office industry organization, IvyPlus Family Office Network, participants a panel of alternative investment experts discussed this view. Jason Huemer, head of Matau Capital, reminded the audience that “size is the enemy of returns.”

“Hedge funds are not dead, but they are suffering because of overcapitalization,” said   Huemer. He observed that managers rushing to gather assets from the largest institutions, handicap their ability to deliver performance. In their bid to attract conservative institutional customers, managers lowered their funds’ risk parameters and reduced volatility.

Ironically, however, the drive to gather institutional assets increases managers’ overall business risk. Institutional-sized inflows can suddenly reverse into equally large redemption orders. That strains liquidity and forces managers out of the market. Often, smaller investors in these funds suffer, said the panelists.

The panelists also agreed that investors need to understand how managers measure performance.  The term “alpha” can be subjective, especially as ETFs and other passive strategies are constructed around narrow industry indices or specialized market benchmarks.

This phenomenon is splitting alternative funds into two different camps: an institutional category of funds that perform at or just above a conservative benchmark, and a second category of funds that are smaller, less dependent on liquidity, and offer better performance for greater risk.

In the end, public market volatility remains difficult to manage and virtually impossible to forecast. As a result, said Steven Chrust, of Centripetal Capital Partners, it may be wise to avoid strategies in public markets all together. “Annually, 80 percent of fund managers underperform their indices,” said Chrust. ”Unfortunately, finding the 20 percent who outperform is extremely difficult because the names that make up that group change every year. The conclusion to draw from this is not that equities should be avoided but rather passive strategies, such as broadly diversified of ETF’s representing the equity asset class, and with much lower fee structures, are the best choice.”