Small Hedge Funds Outperform Large Hedge Funds

Multiple studies have shown that smaller, more nimble hedge funds appear to outperform their larger peers. One major reason stated for the difference in performance is that some funds get too large to effectively deploy and manage their assets. Many of these studies could be misleading because they compare apples with oranges; they look at the hedge fund industry as a whole and compare returns of hedge funds with completely different strategies. A more recent study took a more focused look. It compared only those funds that applied an equity long/short strategy. It then further reduced the sample data by only looking at hedge fund firms that managed over $50 million. These remaining hedge funds were divided into (1) small firms that manage $50 million to $500 million, and (2) large firms that manage more than $500 million.

The study confirmed that smaller funds outperform the larger funds on average by 2.54% annually over the past five years. When looking at the past ten years, the smaller funds still outperformed the larger ones by 2.2% per year. It was interesting to see that the higher performance does not seem to be caused by increased risk. “The vast majority of outperformance is due to alpha, not beta, which confirms that higher risk taking does not explain the differential.” Even the worst performing smaller funds “matched or outperformed the comparable Big funds in the vast majority of years.”

The following reasons, among others, were listed for the difference in performance:

  • The most talented managers do not work for larger firms, but start their own firms. They may gain their initial experience in larger firms, but they eventually start their own.
  • Smaller managers can focus on niche opportunities that have great potential, such as small and midcap equities. It would not be worth it for larger managers to go after these same niche opportunities because the investment, even if successful, would make up such a small percentage of the overall fund, that it would barely affect the overall performance of the fund. With opportunities that have a low trade volume, a large fund would also risk pushing up the price on its own investments if it invested too large an amount. The study found that “the number of potential long and short side investments declines by up to 80% between $100 million and $1 billion in AUMs.”
  • Smaller managers are under higher pressure to perform since performance fees make up a higher percentage of the manager’s overall compensation. Larger firms, on the other hand, get most of their compensation from management fees and not performance. Smaller firms also depend more on performance to attract new investors.
  • When managing fewer assets, it becomes easier to focus in on specific areas of opportunities. Larger funds have to move into other areas as well in order to deploy all their assets. As a consequence, their strategies cannot be as focused as the strategies of smaller funds.
  • Smaller firm managers can focus on managing portfolios. In larger firms, the managers tend to spend time managing teams of analysts instead of the portfolio.

To increase accuracy of the results, the study did not consider any backfill data. That’s the history of a fund’s return that was not reported to a database, but was reported after the fact. Using backfill data creates a misleading picture because many funds choose not to report their returns until after they can show that the approach was successful. The study found that backfill returns, also called pre-reporting returns,” were 6-8% higher than “post-reporting” returns. That’s higher than other results we’ve seen.


Smaller Hedge Fund Managers Outperform: A Study of Nearly 3,000 Equity Long/Short Hedge Funds,, February 18, 2013.

Performance of Emerging Equity Long/Short Hedge Fund Managers, Beachhead Capital Management, February 2013.