12 Jul 2008 - Tammer Kamel

Certain hedge fund strategies suffer as assets grow because their opportunity set is finite. Convertible bond arbitrage is a good example of a small opportunity set which can offer decent returns for 10 to 20 billion dollars of capital (across all hedge funds). Beyond that though, there simply isn’t enough opportunity; CB arb offers one to two billion dollars of profit p.a. to be shared by all hedge funds. If the strategy attracts too much capital, as it has in the past, it just means smaller returns for all. (And then losses as excess capital is extracted from the space temporally cheapening all bonds.)

In some strategies the available opportunity set actually shrinks as a fund grows because certain trades become pointlessly small relative to assets under management. Special situation strategies have this problem. Once a risk arbitrage or distressed fund gets large, many potential trades become too small to warrant attention.

Only strategies that reach to basic, exchange traded instruments in the world’s biggest capital markets are immune to scaling problems. This includes commodity and fx programs like global macro and CTAs, certain fixed income schemes and equity strategies that can be applied to entire stock markets and not just certain niches.

Long short funds that make liberal use of beta have little difficulty growing since beta scales infinitely. But of course these funds don’t stay big for long because beta eventually fails and assets are withdrawn. The only long short funds that can get big and persist are the ones that forgo the risk premiums available from various beta sources. Instead they construct market neutral portfolios and live and die by stock selection only.

There are a handful of multi billion dollar long short funds that do this with perennial success. What is interesting, (and not just coincidence), is they are all classic bottom up analysts. Unglamorous as it is, fundamental stock analysis enjoys a very important advantage over almost all other hedge fund strategies: it benefits from manpower. And manpower can be increased as assets grow.

Of course all hedge funds can hire talent as their management fees increase. Small funds especially benefit from this. But for most strategies, the marginal benefit declines with size. Think of a CTA for example. There are only so many PhD physicists that can fiddle with the model. Global macro funds might gain something from hiring a second or fifth or tenth economist, but sooner or later there is nothing gained by hiring another. The diminishing marginal benefit of manpower is characteristic of most hedge fund strategies. But not bottom up stock picking.

Fundamental stock analysis is tedious and time consuming. A capable analyst might be able to comprehensively understand a few dozen companies in one or two related industries. If she has to cover more, depth of analysis necessarily suffers. Each time a long short fund hires a new, capable analyst, breadth of coverage improves without sacrificing depth. In other words, the strategy itself improves with each new analyst.

This phenomenon has a strong theoretical basis: markets are inefficient enough that a market neutral portfolio that is the product of thorough and competent analysis of a small set of stocks will, on average, be profitable. If an organization is large enough to apply the same thoroughness to 5000 stocks then the law of large numbers will facilitate consistent, low volatility returns.

This is why the mega long short funds have such an advantage over smaller and perhaps even more talented competitors. The mega fund can employ an army of analysts thus effecting total, comprehensive analysis on thousands of stocks. No small long short fund can compete with this. The small fund must either confine itself to a subset of the market at a cost of less diversity or invest broadly sacrificing depth of analysis. When the objective is genuine alpha, the smaller fund simply can’t compete. As such, I generally have no interest in a small long short manager unless he specializes somewhere because he simply can’t hope to outperform the top mega funds at broad based investing.

Of course there are many other aspects to generating consistent returns on billions of dollars. But what many of the mega fund’s investors attribute to the magic of the CIO is actually a credit to the scalability of old school thinking and the toil of an army of competent analysts.