Dominique Mielle, Forbes Contributor, described Marco’s study on the impact of hedge fund size on the fund’s ability to outperform the S&P 500.
I came upon a fascinating study by Marco Avellaneda, director of the Division of Financial Mathematics at the Courant Institute of New York University, who presciently asked, back in 2005: “Hedge funds: how big is big?” The first concept he introduces is that of capacity: the total amount of money that can be put to work with a given manager or strategy without negatively affecting performance. He corroborates my experience that some strategies (currency trading for example) have greater capacity than others (distressed investing in my example), and consequently that investors, all things equal, should prefer deep capacity rather than niche strategies.
The problem then becomes, can hedge funds deliver outsized risk-adjusted returns in markets that are highly liquid and efficient? His answer is that they can, to the extent that they offer superior investment skills. And since above-average skills are, by definition, in limited supply, as money (i.e. demand for skills) pours into the hedge fund industry, it begins funding managers whose skills “are not superior to those that are needed for index investing”. Here, academia poetically meets practitioners. Mr. Cohen succinctly remarked in the same panel that “talent is very thin” and eloquently added that he was “blown away by the lack of talent.”
And so, comes the point at which hedge funds are too large to beat the market: they are the market. Professor Avellaneda uses a linear regression to study the marginal return of a dollar invested at any given hedge fund size. As expected, the line is well-fitted and downward sloping, meaning that returns diminish as assets increase. He insightfully extrapolates that the hedge fund industry will no longer outperform the S&P 500 past $2 trillion in size.
The industry first reached $2.3 trillion in 2008 (dipping for two years after the Global Financial Crisis before ramping back up to today’s $3 trillion): precisely the year that started the streak of a ten out of eleven-year underperformance. Naturally, one can wish to invest in hedge funds for diversification. But it will take innovations and changes for a trend reversal in outperformance.Source: https://www.forbes.com/sites/dominiquemielle/2020/10/01/are-hedge-funds-too-big-to-beat-the-sp/#604888089087
To read the article in full, please click here: https://www.forbes.com/sites/dominiquemielle/2020/10/01/are-hedge-funds-too-big-to-beat-the-sp/#604888089087