If hedge fund “overcrowding” was bad for returns, is recent “undercrowding” going to be good?

Not long ago it was commonly assumed that the hedge fund business was getting too crowded – that alpha opportunities were being spread too thin, and that hedge funds were essentially becoming a victim of their own success.

Now, of course, the industry is going through a period of consolidation and has (temporarily, it is hoped) decreased in size.  So is the opposite true?  If hedge funds were a victim of their own success in the past, will they now be the beneficiaries of their own demise?

A new paper by Oliver Weidenmueller and Marno Verbeek of the Rotterdam School of Management at Erasmus University sheds new light on the phenomenon of “overcrowding” in the hedge fund sector.  The duo don’t specifically examine whether surviving hedge funds will benefit from fewer competitors, it appears from their findings that things may be looking up for those that survive the current culling.

The duo finds that when a small hedge fund experiences outflow of capital, its excess return (defined as alpha) tends to be much higher.  Conversely, when a small fund gets a large inflow of new capital, its excess return tends to be lower.  This makes a lot of intuitive sense when you consider that small funds often produce returns from relatively small pricing anomalies in the market.

But as you can see from the chart below from the paper, the opposite relationship holds for larger funds.  For them, a outflow of capital is related to slightly lower excess returns and inflows are related to higher returns (click to enlarge).

Weidenmueller and Verbeek hypothesize that the investment strategies of smaller funds can’t handle large inflows of capital all at once, but that larger funds a) use more scalable investment strategies, and b) benefit from other economies of scale.

If you look at this graph carefully, you’ll also notice something else kind of interesting.  Large inflows into big funds have a disproportionately negative impact on excess returns compared to large inflows into smaller funds.  In other words, the relationship between AUM and excess returns is concave for funds that experience large inflows.  (This concave relationship does not hold for funds experiencing large outflows.)

In part, this may explain why some modestly sized hedge funds remain closed to new investors.  Inflows don’t hurt performance of small funds.  But once a fund gets too large, inflows begin to hurt returns (indeed, outflows hurt returns even more).

In conclusion, say Weidenmueller and Verbeek, the growth of the hedge fund sector may hurt returns:

“This leaves us with the question of how the hedge fund industry will develop? The average hedge fund might become a victim of their past performance. The promised returns to investors has spurred large capital inflows in the past. The potential earnings for fund managers has equally led to an increased rate and number of fund incubation. It appears that this growing competition led to less opportunities to generate alpha returns for the average fund. This does not imply all hedge funds will lose their added value for investors, but we can expect that alpha opportunities will become more difficult to identify and be sustainable for shorter time periods. It indeed appears that the industry is maturing.”

Which brings us back to the question of what happens now that so many hedge funds have experienced just the opposite since the beginning of Q4 – asset outflows.  We wonder if the conclusion above could be someday be rewritten as something like this:

“…The average hedge fund might become a beneficiary of their past performance. The losses to investors have spurred large capital outflows in the past. The potential poor earnings for fund managers has equally led to a decreased rate and number of fund incubation. It appears that this shrinking competition led to more opportunities to generate alpha returns for the average fund. This does not imply all hedge funds will add value for investors, but we can expect that alpha opportunities will become easier to identify and be sustainable for longer time periods…”

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