Prior research provides conflicting results about whether performance (e.g., absolute returns, alpha, and Sharpe ratio) decreases as hedge fund size increases. Amman and Moerth (2005, 2008) find that performance decreases as hedge fund size increases; Edwards and Caglayan (2001), among others, find the opposite result; and Gregoriou and Rouah (2003), among others, find no relationship between hedge fund performance and fund size.
With respect to risk, prior studies are in agreement that risk decreases for large funds, as measured by their lower standard deviations. In this paper, we reconcile the various results about the relationship between fund size and performance, and we provide evidence that an important measure of risk actually increases as funds grow very large.
A basic risk of investing in hedge funds is that the fund either i) ceases operations and enters into a liquidation process, or ii) alters its redemption terms in a restrictive manner. We refer to either of these occurrences as a closing event. Returns of funds that close dramatically decline in the 12 months prior to closing (Grecu et al. 2006). In addition, there is an opportunity cost in the period between the fund’s closing and when investors’ capital is returned, and that period is likely to generate additional losses to those incurred prior to closing. Therefore, we focus on the risk that the fund closes. We introduce a model of hedge fund closing, and show that the probability that a hedge fund will close is a function of a number of factors, including i) relative size, ii) absolute size, iii) alpha generation, iv) how closely the fund’s returns relate to equity and hedge fund indices, v) the fund’s ability to exploit market volatility, vi) returns volatility, and vii) capital raising activities.
We find that after funds achieve an AUM size that is beneficial, a further increase in AUM increases the probability of closing. In addition to size increases, in and of itself, being a contributor to increased closing risk (controlling for all other factors), many of the other factors related to hedge fund closing also strengthen as fund size increases. Specifically, hedge funds’ alpha generation and ability to exploit volatility decrease as fund size increases.