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Which Hedge Funds Perform Best in Down Markets?

PerTrac, a provider of analytics, reporting and communications software for investment professionals, released a new report this week detailing the success of hedge funds during years in which the entire sector posted negative performance results.

After taking a look at small hedge funds (where assets under management were less than $100M), medium-sized entities (with AUM between $100M and $500M) and large managers (where AUM was greater than $500M), PerTrac discovered that larger hedge funds tended to perform the best in down markets.

“The conventional wisdom right now is that smaller funds tend to outperform larger funds,” said Jed Alpert, Managing Director of Global Marketing at PerTrac. “But there are periods where larger funds tend to outperform smaller funds, and on average those are in down markets.”

As a result of this finding, Alpert recommends that investors fully understand their portfolio requirements before making an investment. “What are their goals?” he asked. “Is it that they’re chasing alpha in a low-interest rate environment and they want to take on more risk? Maybe a smaller fund is a better choice for them. If it’s more about asset preservation and limiting their risk, then a larger fund might be a better choice.”

“The one caution I have,” Alpert added, “is that these are average results; any individual fund may vary.”

In the study titled Impact of Size and Age on Hedge Fund Performance: 1996 – 2011, PerTrac said that large hedge funds dipped an average of 2.63 percent last year. This compares favorably to small funds, which declined by 2.78 percent, and mid-sized funds, which dropped 2.95 percent. Further, PerTrac found that “during the 41 months since 1996 in which hedge funds of all sizes posted negative performance results, the average large fund lost less than the average small fund in 61 percent of these monthly periods.”

Age is also a factor. PerTrac’s study reveals that since 1996, the cumulative return for the average young fund is 827 percent. PerTrac defines a “young” hedge fund as one that had a start date within the last two years. Mid-age funds, whose cumulative return was 446 percent, were launched within the last two to four years. Tenured funds, which have been operating for more than four years, enjoyed a return of 350 percent.

When broken down, PerTrac found that the average young fund has had 144 positive and 48 negative months versus mid-age funds (which had 136 positive and 56 negative months) and tenured funds (which had 129 positive and 63 negative months).

Thus, it seems that while older hedge funds typically do better in a down market, smaller and/or younger hedge funds tend to post better results overall.

“The way I look at these results is [that] it’s an individual investor’s decision and criteria that are going to drive how any sized fund or any aged fund is going to fit into their portfolio and the allocations that they want to make,” said Alpert, adding that this could point to some interesting things for emerging managers to consider.

“It becomes instructive advice for them. Investors are going to get this data, and they’re going to ask, ‘Well, how have you performed in down markets? How are you going to protect my investment in down years?’ Smaller funds need to be able to address that issue. The data says that this is true 60 percent of the time on average, so there are plenty of funds that offer downside protection that are small funds.”

“It just becomes information that I think will be incorporated into the decision making in that asset allocation process,” Alpert added. “Small funds need to be prepared to address that. One of the challenges of larger funds has been that their funds have dragged behind their smaller brethren. They need to point to some of the other positive characteristics of their investments as well.”

Alpert said that he expects the situation to improve “as we start to see the fruits of the JOBS Act and more generalized promotions of hedge funds in the outside world.”

“My take on it is that we will see rules,” said Alpert. “It’s legislation that congress has passed. I haven’t heard that anyone is going to rescind it, so the rules will come into effect at some point. Given that the election is a month away, my guess is that if [the rules] don’t come out before the election, [they will] will come out right after.”

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