It’s not so bad in the middle

19Oct08

First, congrats to all who passed their exams & better luck next time to those who’ll have to try again.  My overall feeling about CAIA level I is that it was surprisingly light on the quantitative stuff.  I studied performance and risk measures so hard and BAM there are like 20 questions on convertible bonds.  What the hell.  Anyway, in all likelihood I’m taking level II in March and I hope it’s not tacky to admit that I passed.

So, here’s an idea I’ve been kicking around: is it really so bad to be a midsize hedge fund?  Conventional wisdom (also: several McKinsey, E&Y, and PWC surveys) says that size is one of the most important indicators of fund success.  As I’ve mentioned before, a lot of assets is important for soothing institutional investors who worry that the fund might blink out of existence after a few trades go bad.  So, high AUM is part of a self-sustaining cycle where size alone makes it easier to grow your assets ever larger.  Also, your return expectations in fact DECLINE seeing as your investors are primarily institutions.

Which is to say, Joe Pension Fund just wants 8-10% returns net of fees with low volatility.  Small funds have to promise so much more.

Anyway, I’m wondering if the conventional wisdom is maybe a little wrong.  Maybe there are advantages to being midsized, especially in difficult markets.  What advantages could a midsize fund possibly have?

Well, first, lower overhead.  Large firms must necessarily hire employees to fulfill administrative and operational roles that smaller companies can outsource, such as IT and HR (for the record I am strongly opposed to outsourced-only IT teams.  If you have internal systems, you need a little internal IT).  Large firms have more real estate–not just larger offices in general but more offices overall, primarily to support asset raising.

A smaller fund has fewer nonessential employees and lower real estate costs.  If these don’t seem like real advantages, consider the fact that payroll and real estate costs DO NOT SCALE.  There’s no economy gained in hiring 30 people as opposed to 20, and when it comes to office space, you can’t buy just what you need–you end up paying for a whole other floor or office suite just to seat the marginal next employee.

Granted, technology and counterparty costs do scale, but these costs also vary widely from firm to firm.  However, all things being equal, whatever your reduced cost from buying additional Bloomberg licenses, the extra employees using those licenses need to generate value in excess of their pay etc.  If this was a reliable formula, every firm would just hire tons and tons of traders because your profit would be directly related to your number of employees.  Obviously this is not true.

I would love to say that smaller firms can be more “nimble” and get out of bad investments, but this is also patently untrue.  AUM and headcount has nothing to do with the liquidity or timing of a fund’s investments.

Another thought I had on this topic was that midsize firms might be less dependent on large investors.  That is, a fund with assets under $500 million probably has a lot of individual investors and/or investors that are personally known to the manager.  The small firm might have an advantage in retaining assets due to personal relationships and the vastly different objectives of individual investors.  A large firm is likely to have more institutional investors and FOF investors who will walk when peformance is bad.

At this point I can still see how it would be better to be larger–especially in an environment like we have today where large AUM is necessary for spreading your exposure to counterparties, investors, and asset classes.  Nonetheless, I do think it’s interesting to consider that being a big firm does have some disadvantages.

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Tags: CAIA, hedge funds