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:
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.