Why are hedge funds so small?
When you look at the largest hedge funds, they are all worth under $100 billion. However, other buy-side funds, such as sovereign wealth funds (largest worth $1trillion+) family offices (Elon Musk's office is worth over $100 billion), pension funds (largest worth $2trillion+), index fund managers (largest manage trillions), even endowments are either the same size or much larger than hedge funds. Why is this the case? Does this support Fama's efficient hypothesis theory, because if we had an inefficient market wouldn't we expect hedge funds to be much larger?
Ignoring the largely disanalogous comparisons you made, hedge funds generally aren’t huge because (1) the space is substantially more fragmented than a field like index funds, (2) the investment opportunity is smaller, and (3) there are substantially less customers
Cuz it's hard to scale strategies lmao. The landscape is also fiercely competitive so other than the big boys, most funds are small.
The other institutions you mentioned about don't run the directed strategies of HFs.
It says ntg abt Fama due to immense reverse causality and the cyclical nature of efficiency. Less capital makes the market inefficient, more capital ensures efficiency.
You’re using the wrong business models as comps
What business models would you use?
Law of large numbers
why are HFs in general so small when LOs are so large?
The more you trade, the smaller you have to be. A $100B real money fund with a mostly passive strategy may churn over $5b / year. A $1B medium frequency hedge fund will trade a lot more than that - 10% daily churn would trade $25b / year, or five times as much. Ultimately for a hedge fund to make money, someone has to be on the other side of their trades (real money players, index funds, mutual funds, lower quality hedge funds, etc.) and hedge fund capacity will be constrained by how much those players trade.
The 'comps' you mentioned are often investors into hedge funds... they are often LPs... your comp set is 'upstream...' hedge funds offer diversity into their investment portfolios because HF is an alternative asset class that is supposed to be non-correlated to stocks/bonds. The big endowments/SWF/pensions buy stocks and bonds directly, but also pay extra fees (like 2-10x more fees) to get access to talented hedge fund managers. Their goal is to minimize diversifiable risk.
The sources you mentioned seem sample-biased because you say hedge funds are <$100B (OK) and then you cite "family offices" (implying they make HFs appear small, but you selected the largest SFO you can find - which is barely $100B btw - by looking at the world's richest man). Why not look at the average or median family office AUM instead? That would make HF's look big. Your questions appears to reveal an intention to make HFs look small, though, for some reason...
Well lets exclude FOs then. If you take into consideration that sovereign wealth funds and pension funds, many of which are literally worth over $1 trillion, or index fund managers some of which manage $10 trillion, it makes no sense. Especially when many HFs claim they can generate alpha and reduce risk if they really could why aren't they much larger than they are? If you take the average of sovereign wealth funds and pensions funds they are much larger than the average hedge fund. If anything the family office should support my argument. Family offices, which manage the wealth of one person or a small family are in many cases larger than the biggest hedge funds which have potential to way more capital.
So, let us understand what you’re confused about – you’re saying HFs should attract more capital than their investors? Like HFs should be larger than their LPs? Because you’re assuming they outperform their LPs (comparing HF returns to a typical 60/40 portfolio at an LP? Which is a false comparison btw)? I wouldn’t obsess over vehicle type as the main differentiator. HF is just a vehicle type, for alternative assets, typically short-term redemptions/high fees, for investing in public markets… within these vehicle types, you have different strategies and expertise (which you may not find a LO). For instance, covert arb, cap arb, HFT, niche systematic strategies, etc. often don’t exist at LO’s because the expertise/infrastructure is not there. You wouldn't want 100% of your AUM (or even a majority) to be dedicated to such a niche strategy. HFs are on average more flexible/creative in their investment mandates - creating the need to hedge - hence 'hedge' funds. Furthermore, some of these massive-AUM LPs you’re referring to have built-in funding programs: insurance companies collection premiums… SWFs might sell state-owned oil… endowments collect charitable contributions… many have natural constituents as a primary reason for their existence (the insured, the taxpaying citizens, the students/donors, etc.). Investing the proceeds is their secondary function (to keep up with CPI inflation, asset price inflation, etc.). HFs are just one potential way to invest those proceeds (like PE, RE, PC, VC, etc.).
I don’t disagree about your point re: the net returns of the HF space as a whole (relative to fees), but the point about diversifiable risk remains. Perhaps most importantly were the points already made above – that these strategies have limits to them – meaning at a certain point you’d experience ‘slippage’ and the strategy no longer works. It is much harder to find scalable strategies than niche ones – due to this problem. Here’s a simple example: bitcoin trades at $50K on Coinbase and $51K on Binance. As a HF manager, you’d pursue an arb strategy by buying bitcoin on Coinbase and selling it on Binance. Over time, you begin to exploit this strategy so much such that you move the market, and the price of bitcoin converges, such that the arb opportunity disappears. Meaning the strategy is limited in scale.
This is kind of a dumb question once you understand what a HF is, why it exists, and the same for the other fund types you mentioned.
1. Hedge fund investors must be sophisticated. This is basically institutions only. An LO, or a pension fund has no such restriction.
2. Hedge fund strategies often do not scale past a certain AUM. Many rely on being nimble. Do you know how long it takes a capital group to accumulate a stock position? Lol.
3. You can't seriously be comparing a HF with a country's wealth.
4. The investors into HFs are the institutions you mentioned. This is like asking why Apple is bigger than foxconn if foxconn makes such good phones. They cannot allocate *all* their capital to HFs regardless of how much performance they have because these institutions rely on diversification. Alts are a small part.
Also, despite HFs being smaller than PE firms (and charging a smaller fee, typically), the unit economics of a HF are much more scalable than PE fund. A PE fund going from $500M -> $1B fund will need to hire a good amount of additional MDs to source deals and ASO -> VPs to execute, while a HF probably doesn't need to (can just upscale current strategies and maybe hire another analyst).
HFs need to stay small because it is harder to generate alpha the bigger you get. This is the reason why Citadel has been returning capital to investors.
Alpha is a zero-sum game.
You either beat the market or become the market.
At OP, this is a lot of what Buffett and Munger (RIP) talked/use to talk about. When you get to a certain size its hard/harder to find investments. It's basically two fold:
1. Think about a fund overall, if your fund is $100M, eventually you have to find a way to make it $200M. Could take a couple of years and investments but its easier to generate $100M than it is say your funds is $100B, you still have to grow it to $200B eventually (both are extremely difficult). Its the same process, you just have more investors. But that leads to point 2.
2. As someone addressed above, the more money you have it becomes difficult to be nimble. Back to Buffett, to generate returns with the amount of money he has he can only invest in a small group of companies (think AAPl, BAC). Say you're managing $100B, but you find a company worth $100M that you think will go to $200M. That's great, you're not going to buy the whole company and if you buy too much you have to many legal things to worry about, so you buy $10M. Even is the company goes 5x to $500M, your $10M is now $50M, or 0.05% return for the whole fund. That's a good investment, but that doesn't happen all the time, you'd lose money on some small cap that go to zero, and you'd be doing a bunch of research for not that big of a return relative to the fund.
What about investing into a large number of small cap stocks? For example, in the Fama-French model one of the factors is small cap stocks, because they have lower expected returns which makes them have a relatively lower price in comparison to their value.
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