Hedge funds: Alpha decays with age

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Research points to declining returns and greater risk as hedge funds grow older

Mark Chambers: The risk
is in the early years
A research report to be published this autumn will no doubt become marketing fodder for start-up hedge funds. "Do emerging hedge fund managers present an investment opportunity?" is a study by London Business School MBA student Ranjit Sikka. Sponsored by UK financial services group Schneider, Sikka investigated the returns and risk levels of more than 1,100 European hedge funds over a 13-year period.

The report concludes that young hedge funds consistently outperformed their mature counterparts, and that alpha decayed with age. Comparing a start-up portfolio with a portfolio of managers five years or older, the analysis shows that there is a decline in performance equivalent to 100 basis points per month, or about 12% a year.

That new hedge fund managers produce higher returns than their longer-running peers is not so surprising. Most hedge fund managers freely admit to being hungrier in the initial stages, and aware that an impressive track record needs to be built if they are to have any success in attracting capital. Assets under management will also be smaller, sparing them from issues of overcapacity.

What is perhaps more surprising is another finding. Emerging hedge funds are producing higher returns than their more established peers, but that does not mean that they necessarily assume greater risk. Shabir Chowdhary of Schneider Capital Management says: "Volatility of returns is no higher on average for new hedge funds, as managers tend to be incredibly conscious about generating a good and consistent track record in the early months and therefore tend to be more conservative. The larger the assets become, the more likely the managers are to add positions with greater volatility to the fringe of their portfolio."

As assets under management increase do capacity constraints force managers to add positions of greater volatility? Or is it more a case of as a hedge fund grows, or it doesn't have the right staff, the right business model and the right infrastructure, it will be difficult to keep on top of risk management and retain good performance?

Most industry participants are becoming more receptive to this theory, pointing out that the greatest threat facing hedge funds is business risk. According to the report, the average age of a failed hedge fund is 26 months. The reasons given for failure were "operational and business costs that outstrip the fund's ability to increase assets under management and provide consistent positive returns". Having a business model that copes with growth has become as important as having a strategy that produces good returns.

Mark Chambers, head of sales management for Europe at Man Investments, says: "The risk is not that the manager blows up because of poor returns, but because the business is not being run properly, and that typically happens in the early years."

It's a message that has dawned on hedge funds. The majority of hedge funds are independent boutiques and, according to a survey by KPMG, are intent on remaining so. Although most managers are expecting double-digit growth in funds under management over the next three years – bringing the critical mass they need to attract investors and benefit from scale – there is a greater awareness of avoiding the pitfalls of becoming an asset gatherer.

Vega is a prime example of a large fund that struggled to balance size with returns. By July, Vega's assets under management had fallen to $6.7 billion, from a peak of $10.4 billion the previous year, and it announced that it would be streamlining portfolios. Hedge fund managers intent on survival know that they have to manage growth as any other business, even if it means turning away money. One hedge fund manager says: "You should know your capacity and once you've communicated that to your investors, don't get greedy and then extend it. Nothing annoys investors more. Just close."

At the same time, hedge fund managers are becoming aware that as businesses they need to consider their ability to manage people and not just money. "The professionalism in the industry is increasing. Compliance officers are being brought in and staff hired. Maybe if you're a hedge fund running $100 million you can manage with two people and an assistant. But if you have a great year and get up to $600 million, you're now going to have to manage people – not just money," says Randy Shain, executive vice-president of due-diligence company First Advantage CoreFacts. "And some individuals just aren't good at managing people. Hedge funds that want to grow need a structure that allows them to do so. It's about how to build a team and reward people."

So while research might prove that start-up hedge funds offer better performance, investors should remember that returns are only a piece of the hedge fund jigsaw and that they should tread carefully. "Yes, I would agree that the majority of hedge fund managers will tend to produce more alpha in their earlier years. But there are also signs of managers that have improved risk-adjusted returns with age. The problem with start-ups is that it is difficult to obtain the full picture," says Chambers. "What we prefer to do as a house is look at and invest in early-stage hedge funds, but never commit client money until we are comfortable. So we get the capacity and open them up as soon as possible but only when we know their business."