Why Small Hedge Funds Have Historically Outperformed Their Larger Brothers – An Analysis by Distressed Debt 1 Hedge Fund

 

 

 

 

 

 

 

 

 

 

  • Historically, smaller hedge funds have fared better during periods of financial stress than large hedge funds
  • Two thirds of global hedge fund assets are managed by only the top 6% largest of all hedge funds
  • Numerous studies have found that, over time, smaller hedge funds & emerging managers outperform the returns of larger hedge funds & established managers

 

With the largest hedge funds (those with AUM ≧ $1 Billion) managing an estimated 90% of the roughly $3 Trillion in global hedge fund assets (1), one may begin to wonder if there is too much money chasing too little talent.  To put this figure into perspective, there are fewer than 400 hedge funds considered to be “large”, while there are an estimated 10,000 or more smaller hedge funds (those with AUM < $1 Billion). About two thirds of global hedge fund assets are managed by the top 6% of all hedge funds (1) (with respect to AUM), and the disparity has only continued to grow, as the number of small hedge funds has declined in recent years as mid-sized hedge funds has ballooned.

A recent study (1) by Barron’s studying the disparity in performance between small and large hedge funds over the past 20 years (January, 1995 – December, 2014) found that, on average, the largest hedge funds returned 0.61% per month, with smaller funds returning 0.75% per month.  They go on to show that in periods of economic turmoil, specifically the Crash of 2008, the smallest hedge funds, on average, lost less each month (-0.48%) than the largest hedge funds (-1.28%), with the largest taking losses at more than double the rate of their smaller counterparts.

Now, let’s explore some of the reasons that small hedge funds outperform their larger counterparts over time, and are also able to whether times of economic stress better than large hedge funds.

An article by the CFA institute (5) poses that the differences found in performance between small and large hedge funds could stem from the contrasting opportunity sets that each provide investors:

The least-followed securities, which are historically the least covered and most inefficient and which often result in higher returns and potentially outsized track records for small hedge funds, are no longer able to be part of the opportunity set for larger, established hedge funds” (5).

It’s amusing to think that when Hedge Funds were first structured, they were truly used to “hedge” against market volatility and produce alternative returns to what the overall market has provided–now it seems quite the opposite, with large hedge funds all converging around the same “large” market opportunities, facing intense competition from one another due to the extremely limited and picked over pool of opportunities, each delivering nearly identical performance as the next.  Common sense tells us that if you do the same thing as everyone else, you’re most likely going to end up with the same results as everyone else.

Smaller hedge funds have an absolute advantage when comparing opportunity sets because they can participate in the “long tail” of smaller-cap market opportunities that most large hedge funds are too big to come near.  The Distressed Debt 1 Hedge Fund’s focus in these types of niche or “long tail” strategies have allowed for the “outsized track record” that the excerpt above mentions, finishing off the first month of 2018 with a Compound Annual Growth Rate (CAGR) of 43.877%, and on 2-9-18, Distressed Debt 1 was ranked 1st for Highest CAGR by Hedgeco.net (a database that tracks the performance of over 9,000 hedge funds).  

“In addition, these relatively smaller market capitalization securities… are often more uncorrelated or at least less correlated…”. (5).

In today’s equity-hungry market, holding a portfolio with a negative correlation to the overall market is a preferred method of minimizing the impact of significant market volatility and can offer substantial diversification benefits.  One common measure of correlation to the overall market volatility (market movement) is beta (β), with a beta of 1.0 representing perfect correlation with the market, and a beta of -1.0 representing perfect negative correlation with the market (example: If the market as a whole moves up 1%, a portfolio with a beta of 1.0 will also move up 1%, in this same market scenario a portfolio with a beta of -1.0 would move down 1% because it is perfectly negatively correlated with the market).  

 

A prime example of how these “smaller” opportunities are generally non-correlated to the overall market can be seen in Durig’s Distressed Debt 1 LP Hedge Fund, which actively participates in a niche strategy focused in Distressed Debt.  Distressed Debt, as an asset class is typically non-correlated with the overall market–the Distressed Debt 1 Hedge Fund has a beta of -0.74.  It has been shown that portfolios of Distressed Debt and other alternative assets tend to outperform more traditionally composed portfolios over time, especially when actively managed.  Learn more about the benefits of Distressed Debt in “Distressed Debt Hedge Funds Can Deliver Surprising Performance”.  The most recent performance of the Distressed Debt 1 Hedge Fund is shown below.

Many hedge fund managers employ strategies centered around capturing inefficiencies in the markets, but as efficient market hypothesis shows us, these inefficiencies do not last forever.  When combined with the weight of a hedge fund exceeding $1 Billion in AUM, these types of niche strategies have a tendency to move the market over time, and are quickly depleted.  This is not necessarily the case with smaller, more agile hedge funds, whose size more or less allows them to “fly under the radar” for much longer before the rest of the market catches on and the inefficiency is depleted.

Distressed Debt 1, Durig Capital’s Hedge Fund, also falls into the category of “smaller” hedge funds, but is  part of an even smaller area of the hedge fund market- Distressed Debt.  With total global hedge fund assets at roughly $3 Trillion, “Distressed Debt” relative to the hedge fund sector could certainly be considered a “niche”, with just a hair over $100 Billion in AUM considered to be “Distressed Debt” among total global hedge fund assets at the end of the 3rd Quarter of 2017. (9)  We believe that Distressed Debt 1’s smaller size has been a large component of our success in pursuing these less followed opportunities, allowing us to be more nimble in our execution.

As one Yahoo analyst puts it, “if you try to put a lot of money into a niche strategy, you are going to move the market both when you buy and when you sell, and your performance is going to be hurt because of it” (2).  

Larger hedge funds tend to be more risk-averse in their approach, and generally see less volatile returns than smaller hedge funds / emerging managers, and in a single year have a decent chance of outperforming smaller funds, but over time, smaller hedge funds outperform large hedge funds.  This is most likely due to the tighter distribution of large hedge fund returns coupled with small hedge funds and emerging managers accessing vastly different opportunity sets which allow for prolonged exploitation of market inefficiencies or outsized returns.  A recent study by Preqin (6), a leading provider of economic and financial data, has found similar results, and are best represented in the graph below.

 

 

 

 

 

 

 

 

 

 

 

 

 

(6)

The data seems to point to smaller hedge funds offering higher returns than large hedge funds to investors with a longer investment horizon.  Another article (8) has found a similar trend in their study of the returns of roughly 3,000 equity long/short hedge funds, both small and large, over the 10-year period (January, 2003 – December, 2013), and are best represented through the following graphs:

 

 

 

 

 

 

 

 

 

(source: allaboutalpha) (8)

The same article (8) then looks at the performance data of the same set for the periods of the 2008 Downturn, and the lead that smaller hedge funds realized becomes even more evident:

 

 

 

 

 

 

 

 

 

(source: allaboutalpha) (8)

These graphs seem to support Barron’s analysis (1) over the same period, with smaller hedge funds faring much better than their larger counterparts in periods of financial stress.

As the majority of market participants have their sights set on the activity of the 400 largest hedge funds, whose opportunities are usually the most-followed in the market, one may wonder how institutions are fairly evaluating the remaining 10,000 smaller hedge funds.  The reality is that these smaller hedge funds do not receive the same type of attention, and are often missed or passed up for a larger, more established name, only helping to further this inequality.  

With the data pointing to smaller hedge funds and emerging managers coming out ahead in performance over longer investment horizons than their larger counterparts, it is clear that if investors are seeking higher returns with less correlation to the overall market, investors should broaden their horizons to include smaller, more nimble investment vehicles and asset classes.

 

Randy Durig

Distressed Debt 1 Hedge Fund
distresseddebt1.com
Toll Free: (877) 359-5319
Fax: (971) 732-5121
E-mail us at: Info@Durig.com

Durig Capital, Inc.
Registered Investment Advisor
durig.com
Toll Free: (877) 359-5319
E-mail us at: Info@Durig.com

 

Disclaimer:

Information here is provided for informational purposes only and is not offered as advice with respect to any particular security or related financial instrument. This information should not be used as a basis for making an investment decision and must not be treated as a substitute for seeking advice from a licensed professional. The suitability of a given investment for a particular investor depends on a number of factors, each of which should be considered carefully. Such factors include, but are not limited to, the risk associated with the investment, the nature of current market conditions, and the investor’s objectives, personal needs, and specific circumstances. This is neither a solicitation to buy nor an offer to sell to persons in Texas. The Distressed Debt 1 Hedge Fund is not available for State of Washington residents.

Resources:

  1. https://www.barrons.com/articles/how-small-hedge-funds-outperform-bigger-rivals-1448691462
  2. https://finance.yahoo.com/news/expert-why-smaller-hedge-funds-163028027.html
  3. https://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/HedgeFundOfFund.pdf
  4. https://www.evestment.com/project/impact-size-age-hedge-fund-performance-2015-edition/
  5. https://blogs.cfainstitute.org/investor/2015/05/19/small-hedge-funds-complement-large-ones/
  6. https://www.preqin.com/blog/0/12706/hf-performance-by-size
  7. https://corpgov.law.harvard.edu/2016/06/14/the-optimal-size-of-hedge-funds/
  8. http://www.allaboutalpha.com/blog/2013/02/18/smaller-hedge-fund-managers-outperform-a-study-of-nearly-3000-equity-longshort-hedge-funds/
  9. https://www.barclayhedge.com/research/indices/ghs/mum/HF_Money_Under_Management.html
  10. https://www.bloomberg.com/news/articles/2018-02-06/hedge-funds-shorting-volatility-forced-to-puke-as-stocks-drop

For more information or questions concerning Distressed Debt 1 (DD1) please ask here, and we will try to get back to you shortly.

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