Small Hedge Funds Struggling

As reported in a recent WSJ article, small hedge funds (those with less than $1 billion in assets under management) are struggling to not only beat the market, but also stay in existence. The impact is seen below in a chart from the WSJ article, by way of Hedge Fund Research, Inc.

Source: Hedge Fund Research, Inc., Wall Street Journal
At the end of 2007, 87% of all hedge fund money was in funds with $1 billion or more assets under management, and 60% was in funds with at least $5 billion in assets. Furthermore, while the number of hedge funds has grown to over 8,000 from only a few hundred just 10 years ago, only 1,152 new funds were launched in 2007. While 1,152 is still a large number, this figure is down 50% from the 2005 peak. When you also consider all the funds that were either merged or went out of business, the net number of new funds was even lower at 589.

The shift towards larger funds appears to be occurring for a number of reasons. For one, smaller firms are having difficulty borrowing funds, making strategies that utilize leverage much more difficult to employ. Some lower cost mutual funds are also beginning to act like hedge funds using various replication strategies, thereby giving investors other options. Institutions and pension funds, which are increasingly looking for alternative investment opportunities, are also choosing to allocate capital to larger hedge funds, which many believe are safer, given their larger capitalization and risk management (i.e., hedging) practices. The more flexible smaller funds have at times generated higher returns, but given the current market environment, larger funds with better risk management have made up for their lack of flexibility. Given that some smaller funds can spend up to $1 million or more a month for staff salaries and expenses, along with the reality that it may be a while before some hit their high water marks and can begin capturing 20% or more of profits, it is becoming more difficult for these funds to contend with current cash burn rates. As a result, don't be surprised if more smaller funds either change strategies, close down, or merge with the larger funds as the credit problems continue to unwind, and new capital continues to get allocated to hot markets, such as commodities and energy.