“It means that smaller hedge funds will disappear,” observes Andrew
Ang, professor of finance and economics at Columbia University’s
business school. Bigger funds are in a better position to have good
risk management and can borrow more cheaply, he points out, and are
more likely to have a track record.
“There is a magic number
where economies of scale really kick in,” Mr. Ang adds. “It’s at about
$2 billion to $3 billion. With funds smaller than that, it’s much
harder to get significant rewards.”
I disagree with Professor Ang, and with any hedge fund investor that limits itself to $1 billion+ funds. Taking Professor Ang's points in turn:
1) Why are big funds in a better position to have good risk management? What does he mean by good risk management? If he means larger funds are more able to hire dedicated risk managers, I think that's more likely to provide only the appearance of risk management rather than the reality, as Ken Akoundi explains in detail. The ultimate guarantor of good risk management is when the investment process is joined at the hip with the risk management process, which is usually truest when one very competent person is doing both.
2) Bigger funds can borrow more cheaply than smaller funds. With "advantages" like this, it seems to me, you don't need disadvantages.
3) Bigger funds are more likely to have a track record. Yes, but fund size is a very lazy heuristic to use to screen for track records. If you the hedge fund investor wish to confine yourself to funds with longer track records--a legitimate aim--the way to do that is to screen for funds with longer track records, not to use fund size as a proxy for track record.
4) Larger hedge funds benefit more from economies of scale. Yes, but the benefits of these economies of scale accrue to the hedge fund itself, not to the hedge fund investors. If anything, hedge fund investors face diseconomies of scale as the size of their funds grows:
a) As a fund grows its universe of opportunities shrinks.
b) If a fund grows by adding new investors, those investors are less likely to share the investing philosophy and expectations of the original partners.
c) Because of a) and b), larger funds are more likely to experience unfavorable style drift.
What does that mean for investors? The implications go well beyond
another phase of pressure on asset prices. As difficult as it already
is, it is no longer sufficient for investors just to come up with the
right asset allocation and responsive risk management; they must also
undertake more rigorous assessment of investor managers to ensure
investment and business models are sustainable.
To do so,
investors should look for firms that remain profitable and, equally
importantly, are playing defensively upfront so that they can play
offensively later in a sustainable fashion. They should also look for
firms that are positioning their business to take advantage of some big
strategic and human resource opportunities that will arise as others
Thanks to Felix Salmon, who sent me this essay by D-squared Digest. I understood . . . much of it. An excerpt:
A somewhat overcomplicated estimator for talent. So basically, a
really excellent fund manager would have the characteristic that
changes in his trading strategy anticipated changes in V. Investment in
this view is a problem of forecasting structural breaks or regime
changes. So if I had unlimited resources of data and mathematical
ability, I would take data on securities prices, and on the trading
positions of the fund under analysis. I would use a STOPBREAK
(stochastic permanent breaks) model to identify regime changes in both,
giving me a vector of dated regime-changes in the equity returns
series, and a vector of dated regime-changes in the trading strategy
series. I'd then use the normal toolkit to estimate the lead-lag
relationship between the two series. Obviously a lead of the trading
strategy series over the returns breaks series would be ideal, but a
short lag would also be worth knowing about - while the man who can
tell you when a big change is coming is a gem of great price to be
treasured, the man who can spot when something's going wrong and stop
losing, is also a highly useful lad to have around, and perhaps a bit
more realistic to hope for. So that's what I'd do if I were in the
manager research game.
A less complicated and perhaps more sensible estimator:
This is a bit of a sledgehammer to crack a nut approach though. I would
guess (and could probably prove if I had three weeks spare time and
masochism to devote to relearning a load of stochastic processes again)
that a reasonably good robust non-parametric estimator for the lead-lag
based talent measure suggested above, would be the number of >10%
drawdowns, which is a statistic that lots of funds will put in their
risk disclosures anyway. I'd specifically divide the average return per
year, by the average number of drawdowns per year, and give myself a
measure of how much return these guys made per "mistake". I'd then take
a look at >20% drawdowns and see whether they were prone to making
In 1969, I wound up my partnership and I had to
help people find someone to manage their money. I recommended Bill
Ruane of Sequoia Fund, Sandy Gottesman, who is currently on the board
at Berkshire, and Walter Schloss, who I wrote about in “The
Superinvestors of Graham and Dodds-ville”. There’s no way they could
But I don’t
know many of the newer investors, they’re not my contemporaries. It’s
not enough to just look at track records. They aren’t predictive and
there will always be a few people that do well. I know guys who can
make 50% a year with $5 million, but not with $1 billion. The problem
with guys that do well is they attract so much money that it
neutralizes their advantage. It’s hard to identify them, and even
harder to make a deal to keep them from attracting other capital. It’s
like betting on a 12 year old horse that won at 3 years old. It’s also
important to avoid managers who use leverage. It’s the reason that
investors with 160 IQs flame out.
Off topic: The best things in life are free--like listening to this interview with the late Richard Feynman, courtesy of the Manual of Ideas blog. Awesome.
By the way, Feynman was a great student and practitioner of seduction--the naughty kind, not investor seduction.
Update: Actually, not so off-topic. In addition to being a great scientist, Feynman was one of the best students of the philosophy of science, of the scientific method and, perhaps most importantly, of the many human and institutional enemies of the scientific method. How do we know what we think we know? What factors can get in the way of knowing? These questions are important to ask of any self-styled expert, including investment managers.
Fidelity's Anthony Bolton, the nearest thing this country has to a
Warren Buffett, told the National Association of Pension Funds on
Wednesday that stock markets were "at or near lows", echoing a call he
made at the turn of the year.
"You could argue that value investors could have invested with a
greater margin of safety," said John Buckingham, who manages the
value-oriented Al Frank Fund.
Tantalising opportunities to buy
seemingly enduring franchises such as Bear Stearns or Fannie Mae for
pennies on the dollar became painful lessons in risk management and
"The problem that value managers face is that
we're closet quants," said Mr Buckingham. "When you're looking at what
has worked historically and what valuations were at that time, you want
to back up the truck and go in."