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Submitted by: Pavan Srinath

Post the Bernie Madoff Scandal, investors have shunned fledgling hedge funds. Instead, they are opting for larger funds with distinguished records. But smaller funds have their own advantages. The financial crisis have brought down the hedge funds heavily. The damage was further magnified by the carnage caused by the Bernard Madoff Ponzi scheme. Since the Madoff Scandal happened, which is till date the largest financial fraud in the history of U.S., many investors are wary of investing in small hedge funds. Investors are now focusing on large portfolios with long track records. A study conducted by investment researcher PerTrac illustrates the draw backs of large funds. To determine the impact of size, investors divided the funds into three groups. Funds with less $ 100 million in assets, those with $ 100 million to $ 500 million, and portfolios with more than $ 500 million. During the period from 1996 to 2011 the smallest funds earned a return of 12.5 % annually, compared to 10% for the mid-sized group and 9.2 percent for the larger funds.

Trading experts and analysts argue vociferously that small funds have key advantages. “Smaller funds trade more nimbly” says Amy Bensted, who also heads the hedge fund research with Preqin says “The bigger funds have large portfolios that it can be difficult for them to invest in attractive niches”. This gap in performance may persist because small funds have different incentives than the larger ones. To know the reasons, the hedge funds traditionally have charged two layers of fees. Annual management fees which is charged at 2 percent of assets and performance fees which is charged at the rate of 20 percent of profits. For a fund which has less than $ 100 million in assets, the management fee will not cover the operating costs. So to stay in business and generate more returns, small managers must work hard to earn more returns, and making investment in those funds which promise the highest returns. However, large funds have lesser reason to take risks. If a huge fund can hold onto its clients, then the annual management fees will generate considerable income. Statistically, smaller funds are more volatile as indicated by standard deviation. Peter Laurelli, VP of eVestment says “It’s likely that small funds are delivering better returns by taking on more risk”. A decade back most investors in hedge funds were wealthy individuals. The investors were inspired by swashbuckling fund managers such as George Soros who delivered out sized returns by taking on substantial risks. However, after the financial crisis, many investors lost hope in hedge funds. They thought the management fee was too high and delivered less than expected returns. Institutions and Pensions have however have persisted with hedge funds. The new institutional clients have enabled to continue the hedge fund history as they have demanded different investment strategies. Many institutional investors are now seeking hedge fund which minimizes risk. The pressure from the clients has forced many hedge fund managers to focus on safer strategies maintained by sizable teams. Some pensions are steering their funds to young hedge managers. The California Public Employees Retirement Scheme, has been allocating some of their alternative assets to emerging hedge funds. The smallest funds excel in bull markets. To take advantage of managing smaller hedge funds, a new emerging class called the Emerging managers has taken shape. However, picking small managers is a tricky choice, as they have a short or zero track record. The best choices may be managers with very good track records to start their own operations.

About the Author: Mark miller


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