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Hedge fund giants secure grip on industry despite lagging returns

The world's biggest hedge funds are managing more money than ever beforeeven while the returns they provide look less attractive compared to those achieved by younger, smaller firms.

Large institutions managing money for wealthy individuals have always tended to look towards well-established money managers but this trend has become more pronounced following the financial crisis.

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According to data from industry tracker Preqin some 90 percent of assets are now held by just 505 funds worth at least $1 billion. This means a record concentration of assetsmuch of the industry's nearly $3 trillionin older and larger funds, hedge fund database eVestment said.

As a result young funds are finding it even more difficult to attract clients in an environment that is tougher than it has ever been.

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The combination of more demanding clients, higher regulatory costs and the fallout from the financial crisis saw the number of young hedge funds with a 10 month record of managing money fall from a peak of 1,610 in 2007 to 492 in 2013, eVestment data showed.

"It is more difficult for younger funds, if they're not launching with enough assets, to ... get started at all," said Peter Laurelli, vice president of research at eVestment.

However, the study by eVestment, using data from its database of 7,700 funds, showed funds under two years old, outperformed those aged two to five years or older.

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Young funds had the highest cumulative return from January 2003 to December 2013, at 210.56 percent. The mid-age index came in second at 128.93 percent and the oldest, or 'tenured' funds posted returns of 123.69 percent, it said.

"A lot of the big hedge funds that have made a name for themselves have grown so large that it's arguably taken an edge off their performance," said Bill Muysken, chief investment officer at consultants Mercer, which advises and places money for pension funds.

"There are a lot of those large funds that we love, but we'd love them more if they were running half the money, and love them even more if they were running half as much again."

Safe Option?

Many investors who were burned by the volatile markets of the financial crisis have turned to big hedge funds for the more stable returns and safety of size—scale, solid infrastructure and operational security.

But according to eVestment, young funds provide better returns precisely because many are not hampered by size, are better able to time a launch to match market conditions and are generally more willing to take on risk to establish a good track record.

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For Mercer's Muysken, the most important issue is whether a business can grow enough to cover its costs, a figure he put at anywhere between $100 million and $200 million.

"Otherwise it's going to be a disappointing experience all round if we invest and they decide at some point they haven't got a viable business."

There's also a practical issue to consider.

Even when big investors wanted to place a portion of their assets into smaller funds, many were unable to do so because the scale of their business demanded a minimum mandate size, usually around $10 million.

Credit Suisse's 2014 hedge fund investor survey showed only a third of respondents would invest in a fund under $50 million, while just over half could invest in one between $50 million and $100 million and three-quarters could do so in one over $100 million.

New rules, new players?

Small hedge funds seeking to attract institutional investors have also suffered a loss of support from some of their traditional backers, investment banks, following the introduction of new regulations.

Tighter rules demanding that banks have higher levels of capital to protect against risk have resulted in their prime brokerage units, which provide services like financing and stock lending to hedge funds, becoming more cautious.

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"We have to be a lot more certain of ourselves that these guys are the ones that are going to grow, and it may take 3, 4 or 5 years for them to grow into a customer that's meaningful," said a hedge fund consultant at a leading investment bank.

"If you're less than $100 million, a pension fund may love your return profile but say 'I can only write you $10 million and you're at $80 million, come back when you've raised another $20 million," he said.

But while regulation may be hampering the growth of some small funds, other post-crisis regulation like the Volcker Rule—which stops U.S. banks from trading on their own account—may yet boost young funds.

There has been a significant increase in the number of investment banks spinning off hedge funds made up of their trading teams, says Jonathan de Lance-Holmes, partner at legal firm Linklaters, "and there's a lot more to come."

By Reuters

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