Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

Next time you feel life has dealt you a bad hand, spare a thought for the world's most successful hedge fund managers. It seems they're suffering too.

Already frustrated with having to trim hugely fat fees to a level that's, well, still hugely fat, hedge funds are now complaining that they're too big to generate lucrative returns. Yes, you read that right. Unlike any other industry in the world, hedge funds apparently would rather not keep growing, thank you very much, even if with a heavy heart they will still take those 2-and-20 fees.

According to Andrew Law, who runs $11 billion fund Caxton Associates, the post-crisis boom in hedge fund assets has been "both an exceptional and unwelcome development." To match investor expectations of 12 percent annual returns, the $2.9 trillion industry would have to generate gains of about $350 billion a year. And in a world of stagnating growth, stretched asset prices and negative rates, that's really, really hard. "The alternatives industry is inappropriately sized to deliver on clients' return expectations," says Law.

Hedge-Fund Blues
Outperformance is harder to come by in a world of slow growth, negative rates and market swings
Source: Bloomberg

You can almost hear the sound of the world's smallest violin playing. The fact is that hedge fund managers' incentives are stacked in favor of getting bigger, rather than the reverse.

Big hedge funds have, on balance, a pretty good gig. For a start, they tend to live longer than small ones. A 2007 Federal Reserve paper found that larger funds were less likely to fail than smaller funds; another study found that for every $100 million increase in assets under management, the risk of liquidation fell by 36.6 percent. At a time of wild financial market swings, following a first quarter when more hedge funds shut than opened, that matters.

For that very reason, big hedge funds also attract investor money like a magnet. Last year, more than half of funds over $500 million in size received inflows, while more than half of those managing less than $100 million saw net redemptions, according to research firm Preqin. Survivorship bias means that all those big pools of lucrative capital looking to find a hedge-fund home tend to feel more comfortable with a big brand name than a risky upstart -- even if the latter charges less and promises more.

So, the bigger the hedge fund, the more likely it is to survive and grow -- and the more likely it is to profit from and maintain its fee structure. According to Bloomberg News, even after recent cuts, Tudor Investment Corp still charges 2.25 percent of assets and 25 percent of profits; Caxton's new pricing is up to 2.5 percent of assets and 27.5 percent of profits. That's some serious cash if you consider these funds represent about $11 billion in assets each.

Bigger Not Better For Returns
Hedge-fund performance has fallen even as assets under management have swelled to $3 trillion
Source: Preqin

It's true that the industry's net returns have fallen from 11 percent to 2 percent between 2012 and 2015, according to Preqin, even as assets under management have swelled. At the individual fund level, it also looks like performance suffers the bigger you get, according to Barclays research. Maybe, as some surmise, there is simply a finite amount of risk-adjusted returns being divided among an ever-growing field of competitors.

Despite all this, investors will probably stick with the big guys. Even if performance has suffered lately, they still offer alternative sources of returns at a time of negative interest rates when capital preservation is also a priority. Most investors plan on keeping their allocations in hedge funds, a Barclays August survey found, even after some heavy criticism of the industry.

So to actually complain about size rings hollow. It sounds like the kind of poor excuse that belongs on an already long list of hedge fund excuses identified by Morgan Stanley, from crowded trades to "macro headwinds". If performance is the problem, hedge funds could seek new ideas or strategies rather than follow the herd, according to Lyxor strategist Philippe Ferreira. If size is the problem, hedge funds could easily shut their doors. But for now, being big is good business.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lionel Laurent in London at llaurent2@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net