Determining the Optimal Size for a Hedge Fund

Much ink has been spilled in the past few years over the optimal size of hedge funds. Of course, the answer is one of perspective. The financial industry has always been about financial gain and the variety of ways to achieve them. The complicated reality, however, is that two principal parties involved in an investment—managers and investors—do not have fully aligned motivations. Investors are focused on low fees and high returns. Individual managers are also focused on high returns, of course, but they have an interest in higher management fees as well.

Study after study has exposed a consistent—and persistent—issue: as hedge funds grow in assets under management, alpha goes down. A number of identifiable factors come into play that seem to cause the situation. For hedge fund managers and their investors, what determines optimal size will depend on the goals of the fund, the expectations of investors, and the gains to be achieved.

Compensation Structures Correlate to Performance

Hedge fund compensation structures are designed not only to generate income to pay for operational and administrative needs, but also to incentivise investment managers to produce higher returns. The classic “2 and 20” structure is intended to provide a best case scenario: a 2% management fee applied against AUM with a 20% performance fee applied after alpha exceeds agreed performance targets against the gains generated over the target. The management fee covers costs of management and serves as a guaranteed income stream for the firm. The 20% fee functions to drive managers to maximise returns as much as possible, aligning the investor demands for returns with an incentive for managers to produce those returns.

This structure, and variations on it, work well and as intended in the early stages of a fund. In particular, the performance fee does a great job of driving performance. Easily demonstrable, however, is that the math starts to favour the management fee over the performance fee with time. As the AUM goes up, so, too, the management fee. At the same time, alpha begins to degrade, reducing opportunities for the performance fee to kick in.

What becomes notable over time is that investment managers become less focused on returns and more on increasing assets under management. The reason for this change can be two-fold: large amounts of capital becomes harder to move in certain hedge styles and the performance fee incentive becomes less attractive for managers. While priding themselves on their strategy achievements and the reputational value derived from them, investment managers value the hard-dollar compensation they receive for their work and management fees against large AUM become more dependable than performance.

Underlying Causes for Reduced Hedge Fund Returns

The nature of hedge funds is part of the complication. Capacity constraints within markets challenge hedge fund strategies to maintain high returns. Diseconomies of scale can make moving in and out of financial securities difficult in niche markets. Simply put, the high returns offered by alternative investments that outpace mutual and index funds cannot be maintained with growth of AUM. Managers, of course, are aware of this decline and must adjust their strategy in response to it.

Every new strategy that produces high returns is exotic—until it isn’t. Returns attract both managers and investors like moths to the flame, and hedge funds have also become less exotic as an investment. Today, even long-only firms are diversifying their portfolios with a hedge fund component. That level of capital entering the field puts more pressure on the strategy.

Technology has also played a role in diminishing hedge fund returns. With the speed of information flows in today’s financial world, alternative investment strategies no longer fly under the radar like they once did. Market watchers do just that—watch the movers and shakers, including hedge fund managers. In general, investors in hedge funds stand to gain the most through early entry, and that window of opportunity has narrowed significantly as news spreads quickly. Coupled with increasing regulations over transparency and disclosures, maintaining unique or opportunistic aspects of investment strategies have become more difficult to manage against competitors.

What Is Optimal Anyway?

The optimal size of a hedge fund, frankly, has no objective definition. With so many demonstrable reasons that can lower performance returns, firms seeking to answer the question of what is optimal must incorporate their own definition into their strategies. What works best for the firm and its clients are part and parcel to positioning a firm for client acquisition and maintenance. Finding that sweet spot that works for both managers and investors is ultimately the key to answering the optimal question.

Like any other business decision, deciding on the optimal size of a hedge fund will reflect the goals and governance of the firm’s strategy. With the extent evidence that asset growth increases management fees, a firm can decide that is a perfectly fine scenario for profits. Of course, it must then decide how to balance that against client defection for lower-cost strategies that produce similar returns. What is an acceptable client churn rate—which will exists no matter what strategy employed—will play into that decision.

Fighting against capacity has the “simple” solution of closing a fund to new investors at a certain AUM. The smaller size will benefit the issue of liquidity—and subsequently maintain higher returns—against the loss of firm growth. Or, starting a family of funds based on the same strategic goals might be another option, as long as the family funds aren’t cannabilising their investment opportunities. The downside is lack of scalability for the firm. For managers who want to remain small and nimble, increasing AUM with new clients might not be particularly interesting for them relative to the firm’s goals.

The Optimal Size of a Hedge Fund is the One That Works

With all the literature and evidence available today on the complication of AUM in hedge fund strategies, it is incumbent upon managers to devise a credible approach to managing the issue. Investors, especially institutional investors, are aware of that returns degrade as AUM grows and are asking questions. As a result, managers should have a plan to address those concerns by devising an optimal size criteria specific to their strategies that keeps them competitive.

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Frank Caccio is Founder of OpsCheck

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group