Managing Hedge Fund Managers: Quantitative and Qualitative Performance Measures

CHAPTER 2

Large versus Small Funds

Good Things in Small Packages

 

 

One question that is continually being asked is how one can obtain alpha in hedge funds. The most common response is to find a manager that has a unique style or edge. Fair enough. Unfortunately the uniqueness that provides that edge is in many instances quickly duplicated. As money flows to a particular style or fund, the law of large numbers takes over. That is, the difficulty of finding the same advantage in large quantities is greatly reduced. There is a growing body of research suggesting that the elusive alpha can be obtained by focusing on small emerging hedge funds. The logic is similar in the more traditional markets. For example, the inefficiencies are more prevalent and better exploited in the small cap market than the large cap market. Why? Small companies are under-followed by Street research, which means that lots of money is not driving up prices, or in the case of hedge funds is driving out alpha. Additionally, the small cap companies have more focused business plans and the opportunities offer greater rewards.

This growing body of research unfortunately is having only a minor impact on how many investors allocate their capital to emerging hedge fund managers. The situation is quite similar to the old investment philosophy that many trust departments followed in the 1980s: no one ever got fired for buying IBM. Despite its relatively uninspiring performance, compared to several other technology ...