High minimum investment levels have always been a sign of exclusivity in the hedge fund industry. But does a higher minimum investment level mean a higher return? According to one study, the answer may be “yes”.
Kelvin Huang, a Ph.D. candidate at Canada’s leading business school – Queen’s University School of Business (disclosure) obviously spent a lot of time examining this relationship. His findings were published in December in his thesis “The Impact of Minimum Investment Barriers on Hedge Funds: Are retail investors getting the short end of performance.” (available here)
Before trying to figure out if big ticket funds have big ticket returns, Huang collected historical data on minimum investment levels from the CISDM database. As you can see from the chart below from his paper, the number of hedge funds with a $1 million+ minimum grew disproportionately between 1995 and 2005:
We note that this corresponded to a period when institutional investments in hedge funds grew substantially. Institutional investors, of course, almost invariably invest more than $1 million at a time. According to Huang, these big ticket funds tended to be on-shore and tended to have higher performance fees (although funds of funds with high minimums tended to have lower fees.)
The sad truth for retail investors is that the high-minimum funds in Huang’s sample had higher returns than the low-minimum (retail-friendly) funds. The chart below shows that the great strength in the high minimum single-manager funds seems to be that they preserve capital better (funds of funds results were similar):
But Huang also issues an ominous warning:
“We also observe a convergence emerging in the curves of the high and low minimum investment groups commencing around 2002. This is consistent with the Skill Dissemination hypothesis whereby over time, technologies and tools of the trade are becoming less of a black box to managers themselves, leading to convergent performance.”
Still, the difference in returns between the big ticket and small-ticket funds is described in the paper as “quite surprising” – especially in certain hedge fund sub-sectors. For example, a strategy of randomly picking a “stock selection” fund from a pool of high-minimum funds had a better return than a strategy of randomly picking such a fund from a pool of similar, but low-minimum funds.
By now, retail investors out there are likely feeling a little shafted. But wait. It gets worse…
The study also found that the cross-sectional dispersion of low-minimum funds was way higher than that of high-minimum funds. In other words, small-time investors are more exposed to potentially awful funds. As Huang points out:
“This is especially unfortunate for retail investors who are less likely to be diversified…”
Huang examines the relationship between minimum investment levels and just about every other fund characteristic you can think of. So we’ll let you check out the paper yourself (chapters 5 and 6 are relatively easy to read). But here’s one such (lack of a) relationship: apparently minimum investment and probability of a hedge fund dying are unrelated.
In conclusion, Huang says that retail investors get the short end of the stick:
“On the whole, the hedge fund industry possesses some characteristics of a two-tiered system. High skill-type managers will generally prefer to form partnerships with high skill-type clients, and high-skill type clients feel the same about high skill-type managers. Retail investors in the lower minimum investment bracket suffer a large amount of performance risk when performance is measured relative to overall strategy performance in all minimum investment brackets. They are unable to diversify this performance risk away due to wealth constraints, which creates a large amount of fund selection risk…”