If there is one point that we can agree on, no study of hedge fund size relative to hedge fund performance has been conducted that is capable of defending its conclusions effectively against all-comers. The nature of the industry, in terms of its diverse strategies, varying degrees of management competency and numberless external market forces, precludes the possibility of bullet-proof conclusions.

There Are Things We Know  and  Things We Don’t Know

We know that no consensus definition exists for small and large. As a result, no valid conclusions can be drawn by comparing studies with differing definitions. For example, if study “A” caps small hedge funds at $500 million and study “B” caps them at $100 million; significant overlap exists between small and large funds rendering any consolidation of data questionable.

Similarly, study “C” may confine comparisons to a finite universe of strategies, while study “D” adopts a macro view that encompasses hedge funds which ply an infinite variety of strategies. In both examples, attempts at comparing the conclusions are, by definition, flawed.

Taking the argument a step further, imagine that studies being compared were conducted in different years. Comparing a study concluded in 2009 to a study concluded in 2012 would necessarily yield disparate results due to the incongruity of market forces.

We know that we cannot predict how political climate will exert its influence on the direction of regulation and legislation and these forces will necessarily impact the performance of hedge funds regardless of size. Small hedge funds may be able to adapt more readily than large funds or, conversely, large funds may have superior resources allowing them to adapt in a manner that eludes smaller hedge funds.  A recent example of one such change is lifting the general solicitation ban. Future changes may include redefining the parameters which constitute a qualified investor.

We do not know what innovative financial products are on the horizon and we certainly don’t know if they will be more or less suited to the small, medium or large hedge fund. We don’t know at this point what defines a small, medium or large hedge fund.

There Are also Unknown Unknowns

The significant factors affecting hedge fund performance may be unknown unknowns! How are potential investors supposed to govern themselves in this environment? While there is no clear-cut answer, the conclusions reached in existing studies trend in favor of the extremes. That is small hedge funds on one end and large hedge funds on the other, with those in the middle being the poorest performers.

Beyond the Question of Size

Factors other than size are key drivers in rates of return. Investors must look beyond size when choosing a hedge fund. Important factors include:

  • The proven track record of the hedge fund manager
  • The fund’s investment strategy
  • Management and performance fees

The means of choosing a hedge fund hasn’t been distilled into anything resembling a scientific formula. Potential investors will continue to rely on their own good judgment, due diligence and gut instinct for the foreseeable future.



Institutional investors are beginning to take a hard look at ‘40 Act structures as alternatives to hedge fund investment.  This investment vehicle is in its formative years with the most seasoned being barely five years old, yet McKinsey & Company projects inflows to approach $900 billion by year-end 2015.

A Barclays Prime Services study, Developments and Opportunities for Hedge Fund Managers, predicted a less robust $650 to $950 billion by 2018 and Citi Prime Finance offered a prediction of $939 billion by 2017. Considering the fact that liquid alternative funds total a modest $137 billion, the growth projections are stunning.

While inflow predictions vary widely, one thing seems certain; liquid alternatives are going to be increasingly competitive with hedge funds for investment dollars.

What’s in a Name

A ’40 Act fund that uses hedge-fund-like strategies is referred to by a variety of monikers: hedged mutual fund, liquid alternative, retail liquid alternative, registered alternative, registered hedge fund, retail alternative and ’40 Act alternative. However, those in the hedge fund industry tend to favor the term RIC (regulated investment company) or 40 Act Fund.

What is the Attraction?

There are four primary drivers 1) the relative transparency of liquid alternatives, 2) a substantially less expensive fee structure, 3) fewer barriers to investment for the broader retail investing public and, 4) the highly liquid nature of the investment.

Despite the obvious attractions for the retail investor, intrigued by the opportunity to engage in hedge-like investments unhindered by the need to establish credentials as a qualified investor, significant interest has also been expressed by institutional investors, with 29 percent of those surveyed indicating an interest in opening or adding to a position in liquid alternatives.

What About Performance?

Detractors of liquid alternative funds enjoy pointing out that RICs routinely under-perform hedge funds. It is true that 40 Act products managed by hedge fund managers delivered an annualized return of 1.6% over the last 6 years compared to the 2.3% return posted by the average hedge fund.

However, returns may be the least of the challenges liquid alternatives face. Many senior hedge fund managers have voiced serious concerns regarding the ability of a truly ‘hedged” liquid alternatives being in a position to raise cash quickly in the face of significant sell-offs. This concern is shared equally by the SEC which has begun investigating a number of liquid alternative funds with respect to daily liquidity, leverage and the associated risks.

Other Investor Considerations

While lower fees appeal to investors of all stripes, the question of performance remains to be answered with any degree of certainty. There just isn’t sufficient historical perspective on liquid alternatives to draw meaningful conclusions. While a few years of data may seem sufficient, one has to consider the fact that the years involved have been less than typical.

The debates will persist between hedge fund advocates and liquid alternative cheerleaders for some time to come. Future results will define the victor—not the dialogue.


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