AllAboutAlpha has an interesting take on a recently published study regarding the relationship between tenure, size, and returns in fund of funds. Briefly, young, small funds tend to outperform their larger peers, but as they age, small funds underperform funds with more AUM. AllAboutAlpha also points out the really interesting dispersion of size and performance statistics, with some managers reporting under a million dollars while others claim over $8 billion in AUM. There is significant skew towards the larger funds and really fat tails, indicating more or less that fund AUM is anything but normally distributed.
This makes a lot of sense when you consider the average fund of fund investor. A Fund of Fund is not a vehicle for obtaining excess returns. The idea is to gain the risk protection of hedge funds as an asset class while avoiding the idiosyncratic risk that causes occasional fund death (Ospraie, Atticus, Ore Hill, and others are today’s headline failures). What I’m saying is, outperformance doesn’t matter as much as exposure to a large number (some say 20, others recommend as many as 40) of hedge funds, especially good hedge funds that are hard to get into if you don’t have a lot of money or the right connections.
Joe Pension Fund doesn’t have the money or the connections, but he can pool his resources with a number of other investors and take advantage of the fund of fund’s economy of scale and dedicated research department in order to gain exposure to hedge funds that otherwise would have been out of his reach. When this is your goal, size matters.
In order to compensate for lack of access (and consequently, less risk budgeting), smaller fund of funds need to have better performance.
But why doesn’t the investor just go for higher performance, isn’t that the only thing that matters?
Think about why a fund of fund might be large even at its inception. Talented, well-connected management, a team and business plan capable of attracting a lot of capital, and guaranteed access to some desirable funds. Size alone is one of the most important indicators of fund stability. Right now a few large, well known funds are struggling. What you don’t read about is the fact that tiny funds die all the damn time.
So for the beleaguered pension fund manager, if you care primarily about exposure to hedge funds in a sort of portable alpha/downside protection way (and you should), a fund that promises stability through its size requires less due diligence and is ultimately a preferable long-term investment. A large fund, though it underperforms, can still be attractive.
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