Although it is difficult to make sweeping generalisations in the hedge fund industry, one frequent generalisation commonly observed by industry participants is the phenomenon of better performance among early stage hedge funds. The result of serious academic study, this phenomenon was first popularised by a published study by CrossBorder Capital (using data from TASS and the TASS Graveyard Database). The CrossBorder study found that "adjusted for survivorship bias, the youngest decile funds beat the oldest decile by 970 basis points per annum"², a statement often repeated in marketing documents of many funds of early stage hedge funds.

Hence if it is statistically observable that younger smaller funds outperform older larger funds, then one ought to be able to first, come up with certain explanatory characteristics of why earlier stage funds outperform later stage funds, and secondly, come up with a theory on the existence of a discernable hedge fund life cycle, by which the pattern of fund returns may indeed follow the age and growth pattern of hedge funds. Although such sweeping generalisations are practically useless from a statistical forward-looking predictive point of view, they can indeed be of very large practical explanatory value to industry practitioners involved in the hedge fund manager selection process, and to hedge fund or hedge fund of fund investors desirous of gaining insight into the return drivers in the hedge fund industry.

Early Stage Defined

Although it is difficult to give a distinct definition to a hedge fund's life cycle, in general terms, an early stage hedge fund can be defined as a fund within the first few years of its life, when assets under management are below a certain mark, usually US$100-200 million. Such a categorisation is delicate however, as in some strategies and in the case of some managers coming from existing funds, assets raised at day one can easily surpass these levels despite the fact that the fund is in a pure start-up phase. Yet what is very clear for almost every hedge fund is that there is a distinct life cycle which impacts a fund's performance as well as its risk profile.

Explaining Why Early Stage Hedge Funds Outperform

There are a variety of reasons that have been submitted to explain the statistical out-performance of early stage investment funds. Clearly there is no "one" specific reason that can account for the observed out-performance of young hedge funds, but clearly there is a multitude of factors at work. Elements which generally add value to early stage hedge funds and which quite often are lacking in later stage hedge funds are enumerated below. Most of these reasons proposed are quite self evident and in themselves aren't fully explanatory, but taken together offer a powerful investment paradigm in support of early stage hedge fund investment.

Newer market anomalies: As a great majority of the most successful hedge funds in the early years start by exploiting newer market anomalies not yet fully understood or fully priced by the market, this can be a major reason for earlier stage fund out-performance. It takes a while (usually measured in years) for competition to build out so that the first managers to address this market anomaly generally take the lion share. This is certainly true in many strategies. A perfect example of this is return series of convertible arbitrage funds during 2002 and 2003, before the space got really crowded.

Illiquid securities: A great number of the most interesting hedge fund start-ups started their trading careers at proprietary trading desks or other hedge funds as younger traders trading smaller markets. Specialists in smaller markets almost always trade illiquid securities, and this trading paradigm commonly known as "providing liquidity" is one of the most successful drivers behind a multitude of hedge fund strategies. Newer hedge funds, of course, are almost always set up to exploit pricing inefficiencies in "newly popularised" smaller markets, yet as time goes on and competition makes even these smaller markets more efficient returns are drawn down. Yet with all that can be said about the academic theories of market efficiency, some observable extremely good early stage track records attest to the fact that it takes a considerable amount of time (again usually measured in years rather than months) before such inefficiencies are fully priced in the market. This leaves the best early stage managers (in a variety of different strategies) sometimes several years to collect above average returns compared to their peer group before returns in the sector are driven down by too much competition³.

The size argument: Early stage hedge funds are smaller and can thus be more nimble than larger funds. A common trend in the industry for a mature hedge fund with between US$1-2 billion assets under management running a couple of different strategies with large trading teams and in-house administration, risk management, compliance, investor relations departments, tend to be rather large (bureaucratic) organisations lacking an entrepreneurial edge. Some of these organisations have in excess of 100 people, the majority of them employees, whereas the average hedge fund start-up in its early growth years is best kept very lean and mean. In the early stage hedge fund space, where primary services are outsourced and sufficient AUM is provided to keep the firm concentrated on its primary money management function, investment results are invariably better. In such smaller "lean and mean" early stage firms, the decision-making processes are easier and quicker, particularly in the trading room and hence market opportunities can be exploited rapidly as they appear.

Size concern two: Trading larger positions: Large positions in less liquid markets create too much slippage and draw down returns. This is particularly true of managers exploiting niches in some capacity constrained strategies in less liquid securities. Clearly some ideas are only profitable as small trades, despite the fact that market inefficiencies will remain for a long period of time, they are only exploitable by smaller trades⁴. The history of hedge fund experience proves the maxim that one cannot earn a large liquidity premium from trading large positions in illiquid markets, but that one can earn a large liquidity premium by trading small positions in illiquid markets.

More sweat, more hard work and more motivation per dollar of AUM: Early stage investment managers generally are more motivated to extract higher returns. This is explained by the entrepreneurial mindset of every early stage hedge fund start-up, as well as the necessity of early stage managers to grow assets above the breakeven and comfort level. In layman terms, there is a real corporate culture of hard entrepreneurial team work, but as firms grow older and "institutionalise" this edge is lost.

Psychology and motivation: The psychological reason of "making it" as a successful entrepreneurial investment manager is a very strong driver in the early years of a hedge fund. As assets grow and managers reach certain levels of wealth, their working days, as well as their sweat per AUM is reduced so that returns gravitate to an average level.

Putting it all together: When successful early stage funds of funds begin to grow up, they can become very valuable: When an early stage fund has successfully traded a few years and reached critical mass of assets under management, principals of that fund tend to develop a more relaxed mindset. If the investment paradigm is good, and all operational systems are well thought-out and well implemented and there is continuity in the investment-making process, the fund tends to perform in the top quartile of their peer groups, even as returns in its particular strategy may tend to be reduced by capital market conditions. In later years, these types of funds become extremely useful core portfolio holdings for major hedge fund portfolios, particularly for institutional investors who may eventually build out their own hedge fund portfolios but who for the moment are concentrating on hedge fund exposure through funds of funds.

A Hedge Fund Life Cycle Approach to Hedge Fund Manager Selection

It is helpful to look at the hedge fund industry though a classification that places managers along a "hedge fund life cycle" continuum, by which the structures, return streams, motivations, and business organisations of hedge funds evolve over time and as fund assets grow⁵. An explanation of this "life cycle" can be used with success to explain differences in the patterns of returns and the risk profiles in the hedge fund industry, and to understand the repeatability of early stage hedge fund returns as well as their specific risk factors.

As previously explained there are a variety of reasons why early stage hedge funds usually have higher return streams than funds at a later stage in life, and these early years of a hedge funds life are usually noted for a very strong entrepreneurial approach, a quick decision making structure, and a focus on the newest and most successful capital market anomalies, hence their higher return profile. As funds continue to grow assets and as investment returns gain consistence, the middle years of a hedge fund life cycle for successful funds often represent a mature sweet spot growth, in which successful managers are most likely to produce reliable, solid, and quite attractive risk adjusted returns. However, as funds age, special risks often appear, which account for the fact that returns of older, larger funds, or quite often yesterday's stars, are often tomorrow's mediocrity, or some times worse, tomorrow's dinosaurs or disasters.

The following diagram illustrates the hedge fund life cycle concept in visual form. The left hand light green circle represents early stage funds: Essentially, when a new fund is formed, it is set up to exploit the most profitable, more recently "discovered" market anomalies, or in the very least has the best and most entrepreneurial traders which are already successfully exploiting a market niche. In many cases such early stage funds in markets just becoming popularised, have a period by themselves or with a small group of peers, in which low competition and few traders in that paradigm can create sometimes exceptional returns, until other early stage companies come into the same trading paradigm, and drive down returns. Operational concerns and the quest for enough AUM to create a workable business are the major risks. Although investment management risk is fairly small, the greatest risk is not getting AUM to create a workable business and hence returning capital to investors and going back to Wall Street to work after a couple of years as a hedge fund manager. Also, in the early stage there is a host of operational risks which will be enumerated in later sections, but which are addressable.

Clearly, the blue top circle representing hedge funds in the mid-life stage of their evolution is the "Sweet Spot" of the hedge fund life cycle. Generally speaking, business operational concerns have all been well addressed, business processes and risk management controls are well established and at this stage have usually been bought in-house, and there is negligible operational risk. Top quartile funds in this life cycle are excellent potential hedge fund investments for institutional players; they tend to have all the right risk management and controls systems in house, and managers here certainly have an edge in extracting alpha as well as beta from the market paradigm that the fund is exploiting. Funds in the bottom quartile of this stage tend to disappear, not in blowup risk, but as funds that kept trying and trying, and never made it because AUM growth was not sufficient, or because performance was not good enough. A clear pattern here is that the top quartile early stage hedge funds more often than not evolve as the top quartile mid/life cycle funds in their respective strategies, which means that a manager which is able to add value in the early stage investment process usually keeps this as the firm approaches the middle years.

The turquoise circle on the right represents yesterday's stars, which have become today's dinosaurs. Past performance is no indicator of future success, but because past performance has been extremely good, this has been a major drawing card for AUM growth. Most of these funds have closed to new investment, and some in fact are even returning assets to investors, and have exorbitant fee structures, and in fact it is a paradox that these funds are the most sought after⁶. Larger AUM make it harder for these funds to earn a liquidity premiums from less liquid securities, taking away a major return stream that smaller funds can exploit with success. The fact that these funds are usually closed or only open to existing investors makes transparency very low. This in turn makes risk management from the investors' level very difficult to control. Style drift is an important concern here, as many of these funds branch into new trading ideas, the trading niche they founded their business on gets more and more crowded and returns are driven down in their mainline business. Blowups tend to happen here with a much higher frequency than with funds in other stages of the life cycle. Managers tend also to become complacent, with an "if it isn't broken, don't fix it attitude" and tend to adapt poorly to paradigm shifts in the capital markets so if these funds don't blow up, they become only moderately interesting from a return perspective. These funds are so large, that they have become "the industry" both from a size and a return perspective, in fact, so much so that a recent observer at a hedge fund conference found that the correlation of the top fifteen hedge funds by AUM with the HFRI index was slightly in excess of .92.

The Hedge Fund Life Cycle Diagram

Source: author

Clearly, the best returns can be found among funds in the early stage of their investment lives. As these early stage funds develop and grow into successful mid-stage hedge funds, in terms of risk-adjusted returns, operational organisation and business risk, this is the "sweet spot" in their life cycle where they offer excellent investment opportunities for institutional investors.

Footnotes

¹John Dunn is Associate Professor of Finance at Thunderbird, The Garvin School of International Management, French Geneva Center and an Advisory Board Member to Infiniti Capital, a multi-strategy fund of hedge funds.

²Cross Border Capital. "The Young Ones". April 2001. At this point the Tass database had 3733 funds included. This study also points out that the out-performance figures cited hold even after being adjusted for the risk of failure, {the study also included the Tass graveyard database of funds no longer reporting to adjust for survivorship bias}, and the study simply concluded that "investors should buy funds in the first three years of existence." Another study by James Hedges of LJH Global Investments found that the pattern…clearly supports the premise that smaller funds outperform larger funds, and that … size erodes returns." James R Hedges, IV, "Size vs. Performance in the Hedge Fund Industry". Journal of Financial Transformation, April 2004.

³Obviously, many of you will be aware of the academic debate on market efficiency. As hedge fund analysts however, a good deal of our best investments have been made in funds that continue to exploit market inefficiencies over long period of times. Let me remind you of the joke of the University of Chicago {where the theory of market efficiency was first penned} professor and his graduate student walking down the street, and the graduate student, sees a hundred dollar bill lying on the sidewalk. Of course the professor commented, don't bother to pick it up as it is obviously counterfeit, because if it was real the market is so efficient that it would have already been picked up. A pretty theory but it obviously invalidates the cold hard cash that has been earned for investors in early stage hedge fund portfolios.

⁴Particularly in some markets where at position disclosure is an issue. If for trade confidentiality reasons, I can only buy 2-3 percent of a small cap, knowing that at 5 percent I have to file with the Feds and all my competitors will know my positions, this is a fairly firm capacity constraint, particularly if I have to worry about position exit liquidity.

⁵See for example the article by Jeffrey Tarrant, "The life cycle of hedge fund managers" in Ronald A. Lake, ed. " Evaluating and Implementing Hedge Fund Strategies", 3rd edition, Euromoney Publications, 2004

⁶Generally the most recognisable names in the industry, and certainly the ones with the best previous track records. Analysing these older managers is in itself a special task, transparency tends to be very low, tradition high, and these larger funds seem to be slower to adapt to new conditions in the capital markets. How many fund of fund investors have been approached by fund of funds salesmen saying if you invest with our fund, you can that way obtain exposure to xyz superstar managers which are otherwise closed.