The top performers in the hedge fund universe over the last three years have been small or very small (micro) based on 13F AUM. Only Whale Rock Capital, a mid-sized fund with $2.94 billion in AUM, cracked the top ten.
So why do small hedge funds outperform large hedge funds? Here are a few possible explanations:
If you’re a fund manager buying $500K of a moderately liquid stock, you can probably do it easily — without pushing the stock higher. Likewise, when you go to sell, you can likely avoid price “slippage” as you liquidate. As a smaller fund with smaller positions, buying and selling probably has minimal impact on performance.
However, buying $100 million of the same stock is more problematic. Market makers may see your buying and “front run” you, pushing prices higher before you complete the position. On the way out, you can’t just dump all your shares on the market – the stock’s price would plunge. You have to sell the position over days. If you’re not careful, entry and exit inefficiencies can be a major drag on performance.
So as successful hedge funds attract ever more capital, they are forced to gravitate toward large-cap, liquid stocks to efficiently invest their billions of AUM. And highly liquid stocks may not offer the same profit potential as those with less liquidity.
A manager of a small firm can do much of a fund’s research personally. But as any entrepreneur knows, as a firm grows, a point is reached where the founder can’t do everything herself. Crucial tasks must be delegated. This 2009 study showed that at hedge funds “the number of principals compounds the effects of size on hedge fund performance. Specifically, the alpha spread between small and large funds is almost twice as large for multi-principal funds as it is for single-principal funds.” Large funds must delegate responsibilities to other, possibly less talented analysts, negatively impacting performance.
SKIN IN THE GAME
When hedge funds start out, most of the capital under management is usually that of the principal(s)/manager(s). If the portfolio does well, the principals do well, their clients do well, and the fund can raise more money. But as AUM gets larger, a greater percent of the principals’ compensation comes from the asset-based management fee. As AUM grows, so does the principals’ incentive to focus on raising more capital versus generating great performance.
Small fund managers tend to have more of their own money invested in the fund. As such they may be more focused on portfolio returns versus raising capital. This study suggests that investors are more likely to earn higher returns by investing in small hedge funds whose managers have more “skin in the game.”
SMALL CAP STOCKS
Small hedge funds tend to invest more in companies with smaller capitalizations. While this may result in greater volatility of returns, on balance small cap stocks tend to outperform large caps. This so called “Small Firm Anomaly” may help explain small hedge fund outperformance.
WHY DO SMALL STOCKS OUTPERFORM?
Small public companies often have little or no analyst coverage, and so may have unknown potential. Smaller companies have greater growth potential than large companies: A tiny public company can triple its revenues with one contract — that’s not going to happen to Apple Computer. Likewise, when small firms fix problems, the resulting improvement in profits can drive big price gains. Small cap stocks also tend to have lower stock prices, resulting in greater price appreciation compared to big firms with higher prices.
For talented managers, the small-cap sector may offer greater opportunity to apply their skills at finding emerging and undervalued companies.
So, Jimmy Buffett isn’t writing hits like “Margaritaville” anymore; and Warren Buffett isn’t generating returns like Berkshire Hathaway had back in the day. They’re still good at what they do and have more fans than ever.
But if you’re looking for stellar returns by following the leading hedge funds with the best ideas, you’ll likely make more money studying the moves of the small fund managers, the ones who aren’t famous. Yet.