Bigger hedge funds could pose greater risks, says White Paper

InvestorsOperational Risk
12 Nov, 2010

Larger hedge funds might not be as safe as people think, according to a recent white paper by the New York-based private investment management firm, Spring Mountain Capital (SMC).

“The Relation between Hedge Fund Size and Risk” white paper by Haim Mozes, senior consultant at SMC and Jason Orchard, a principal at the firm, argued there are declining benefits to investing in larger hedge funds.

The white paper identified a number of factors that increase a large fund’s risk profile relative to its smaller peers. “Managers of large funds are confident that a good performance will be maintained, therefore warding off investor redemptions, but eventually, fund size will hinder performance enough to trigger a redemption cycle that has a strong negative feedback loop,” according to the authors.

The paper highlighted large funds tend to generate lower alpha and don’t always exploit market volatility to the same degree that smaller funds do. It added large funds often compensate for their lower alpha and inability to exploit volatility by having higher beta. It also said bigger funds can sustain poor performances before having to shut their doors to investors over longer periods of time than smaller funds.

"Large hedge funds may be perceived as less risky than smaller ones, but our research and experience suggests that this focus may be misplaced; and in the future, the opportunity costs of investing in large funds may be higher and the safety benefit of investing in large funds may be lower than investors currently expect," said Orchard.

SMC's methodology included analysing's database of live and dead funds (funds that have ceased reporting), which contains performance data for 7,545 live and 8,916 dead funds from 1995 through May 2010.