In a fight between large and small managers, who wins?

Large managers are a better investment than small managers.

That was the resolution at the 14^th annual debate hosted by the Alternative Investment Management Association (AIMA) Canada.

“The belief that small managers outperform is […] an alternative fact,” says Alex Da Costa, the first debater, to audience laughter. He’s managing director of hedge funds at Pavilion Alternatives Group.

“Globally, managers running over $1 billion control 90% of industry assets,” he says. “Investors have voted with their dollars.”

To address the contentious claim of better performance, Da Costa provides analysis of the performance of both large and small funds (over $1 billion and under $500 million, respectively) over three, five, 10 and 17 years.

His finding: over the 10- and 17-year periods, larger managers outperform on an absolute and risk-adjusted basis. Over 17 years, for example, risk-adjusted results are 11.4% for larger managers and 10.8% for smaller managers.

Over shorter periods, small managers outperform on an absolute basis. But they exhibit greater volatility, says Da Costa, and thus have less attractive risk-adjusted returns.

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He also highlights the failure rate of smaller managers. “After about four years, 25% of smaller funds have liquidated,” he says, again citing his research. “Over six years, the number goes up to 50%.”

And, during periods of crisis, the failure rate is particularly stark. From 2008 to 2010, the failure rate was 20% for small managers versus 5% for large, he says.

Besides better performance and lower failure rates, Da Costa lists several reasons why large managers attract the majority of assets, including:

• the ability to innovate, as well as to hire and retain the best talent, and
• the depth and scope to form partnerships with investors.

Playing small ball

Debating opposite Da Costa was Marlene Puffer, partner at Alignvest Investment Management. She calls out Da Costa for presenting a tautology: the fact that large managers control the majority of assets says nothing about relative performance, she says.

Citing an academic paper on hedge fund research, she says, “There are decreasing returns to scale that outweigh any economies to scale in the hedge fund universe.” And this finding holds across all strategies, various periods and multiple databases.

Correcting for various things, like factor exposures, “the alpha generation by small managers is on the order of 4% to 6% annualized,” says Puffer.

Further, she argues smaller managers are more innovative, citing academic research based on clusters of managers using niche strategies. The first quintile in that space outperforms by 50 basis points per month, she says, until the clusters grow large.

Refuting Da Costa’s argument that large managers attract talent, she says many small managers are started by former top talent at large managers, adding that diseconomies — of large teams, for example — motivate that attrition.

She also addresses Da Costa’s argument of greater stability, noting that of the $3 trillion in hedge funds, more than 10% is in multi-strategies — essentially funds made up of smaller funds using various strategies. For managers with more than $5 billion in assets, 23% are multi-strats. For those with less than $500 million in assets, only 6% are multi-strats. “Those larger funds that tend to survive […] tend to be emulating the style of […] small managers,” says Puffer.

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She further notes that the larger a manager gets, the more the strategies tend to correlate with the market. “The standard strategies end up, almost inevitably, having factor exposures that leave them with less benefit in terms of their marginal contribution to a portfolio’s risk-adjusted return.”

In one of several humorous asides, Puffer also notes that academic evidence reveals that managers from undergraduate institutions made up of students with higher SAT scores outperform those from schools with lower scores. “Where was it that you went to school?” she chides Da Costa.

The winner was decided by a show of hands from the audience. Puffer clearly came out on top, confirming — for one afternoon, at least — that smaller is better.

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