Not all hedge funds are created equal, and while some start out with a strong performance, many decline over time. The question is, why? In a new paper, “Size, Age, and the Performance Life Cycle of Hedge Funds,” researchers dig into the factors that contribute to declining performance in the hedge fund space, pointing to the fact that many hedge funds have disappointed since 2008.
Using an event time approach to examine the performance life cycle of hedge funds, the authors find that size definitely matters — smaller funds on average provide better performance at different stages during their life cycle. This is mainly due to growing diseconomies of scale, particularly after the first year.
Manager performance incentives are a key factor: incentives decrease with fund size and, as the a fund ages and grow, the incentive effect is exacerbated. Investors who are inclined to blame performance declines on lockup periods and high-water mark provisions might want to rethink that assumption – the authors find no link between those factors and poor performance. They also rule out the inclination among young managers to take on higher downside risk as a contributor to the age effect.
As the authors conclude: “While prior studies have linked diseconomies of scale with lower performance in panel data sets, we show that diseconomies of scale drive down performance in a time series context and that the weight of the management fee, which increases with both size and age, may provide a disincentive to chase performance when funds grow large.”
So clearly smaller is better according to this research – and investing in small funds, regardless of their age, could lead to superior, sustainable returns. Read the full paper.