May 12, 2014 Stephen Taub

The largest hedge fund firms and their investors have something of a love-hate relationship. On the one hand, the growing ranks of institutions pouring money into hedge funds and other alternative investments prefer firms with deep benches, solid infrastructure, sophisticated risk management and a large team of portfolio managers and analysts sleuthing for investments. On the other, investors are mindful of studies consistently suggesting that smaller, younger, even fledgling funds outperform bigger, older, more seasoned funds.

Overall, large size is generally bad, says Michael Hennessy, director of investments at Morgan Creek Capital Management, a fund-of-hedge-funds firm based in Chapel Hill, North Carolina. The industry started out as boutique-ish, and the subsequent significant increase in size and institutionalization — as we have seen over and over — is seldom a good thing. At the fund level it generally impedes nimbleness, flexibility, liquidity and results, depending upon the strategy.

Hennessy acknowledges that most big managers started off small. The harsh, Darwinian nature of the business has resulted in some evolution of the fittest [firms], which are incredibly strong, skilled, well resourced and high performing, he says, noting that while Morgan Creek invests with some of these, most of its capital is invested outside the biggest firms that rank among the Hedge Fund 100.

Still, many institutional investors hold their noses and send a disproportionately large slice of their hedge fund allocations to the biggest funds. This reality is confirmed by our 13th annual Hedge Fund 100 ranking. At the start of 2014, the world’s 100 largest hedge fund firms managed $1.51 trillion, up almost 14 percent from early 2013, when they had $1.33 trillion. Over the past two years, assets of the top 100 hedge fund firms have surged nearly 25 percent.

Industrywide, assets grew in 2013 by 9.7 percent, to $2.85 trillion, after rising 5.9 percent the previous year, according to Marietta, Georgia, data provider eVestment. The top 100 firms account for more than half of total industry assets, and their share has been increasing.

The rate of asset growth for the top 100 far exceeds the average of hedge funds as a whole in recent years. The HFRI Fund Weighted Composite Index rose 9.13 percent last year and 6.36 percent in 2012 after posting a 5.25 percent loss in 2011. This suggests that performance is not the only driver of asset growth.

Most of the new money that the big funds are getting is from public pension plans, says Maneck Kotwal, an investment officer at the New Jersey Division of Investment. Kotwal notes that hedge funds once received large amounts from foundations and high-net-worth individuals. Now pensions provide a significant share of funds. Because of their size and being in the public eye, pension funds gravitate to the larger firms, he says. It’s the same reason they used to buy IBM.

As larger pension plans move into alternatives, they need bigger funds to put $50 million or $100 million to work. If they give, say, 20 funds $5 million apiece, they wind up with too many funds. Everyone is on the prowl for smaller, nimble funds, says an executive at a large hedge fund allocator. But a lot of experienced funds are run by investors with impressive track records who have seen different market cycles and have built organizations that have started to transition to the next generation.

But while many investors prefer to invest with the largest firms, not all those firms welcome the affection. A number of major firms closed some funds to new investors last year, among them Citadel, Convexity Capital Management, D.E. Shaw & Co. and Viking Global Investors. Others returned significant sums of capital to investors in 2013, including Boston’s Baupost Group, which gave back $4 billion. Short Hills, New Jersey–based Appaloosa Management; Boston’s Highfields Capital Management; and New York’s Third Point each returned $2 billion.

For the fourth straight year, Raymond Dalio’s Westport, Connecticut–based Bridgewater Associates ranks as the world’s largest hedge fund firm, with $87.1 billion under management as of the start of 2014. The firm’s assets rose 4.6 percent last year. Bridgewater’s Pure Alpha (12% Volatility) rose just 3.5 percent in 2013, Pure Alpha Major Markets was up 5.25 percent, and All Weather (12% Volatility) lost 4.62 percent. Over the past ten years, these three funds compounded at 8.6 percent, 11.8 percent and 7.7 percent, respectively.

Also for the fourth year in a row, New York–based J.P. Morgan Asset Management, which owns Highbridge Capital Management, comes in second, with $59 billion. Last year Highbridge, a $4.5 billion multistrategy fund, rose 6.5 percent after gaining 9.79 percent in 2012 and dropping 5.11 percent in 2011.

Jersey-based Brevan Howard Asset Management lands at No. 3 with $40 billion in assets, the same as the previous year. It has ranked in the top five for the past six years. The $27.8 billion Brevan Howard Master Fund posted a 2.6 percent gain, avoiding its first down year.

Daniel Och’s Och-Ziff Capital Management Group ranks fourth with $36.1 billion in assets under management, up almost 20 percent. The firm is really the only rapid asset-grower in the top ten. It’s no coincidence that Och-Ziff is the only publicly traded alternatives firm specializing in hedge funds. Investors in Och-Ziff stock, which trades on the New York Stock Exchange, value the shares in part based on the firm’s income growth and dividends, which depend on growing assets. Equity investors like a smooth upward trajectory in fees.

As a result, the performance of Och-Ziff’s funds tends to be lower than many others, if steadier. Last year the firm’s flagship OZ Master Fund gained 13.9 percent, its OZ Europe Master Fund rose 12.4 percent, and its OZ Asia Master Fund returned 13.5 percent. New York’s Och-Ziff generated these returns with less than 37 percent of the volatility of the S&P 500 index on a weighted-average basis, Och pointed out in a conference call with equity investors.

This year three firms hit the top ten for the first time: AQR Capital Management, Lone Pine Capital and Viking Global Investors, the latter two founded by Tiger Cubs (former portfolio managers of Tiger Management Corp.’s Julian Robertson Jr.). Greenwich, Connecticut’s AQR currently has more than $105 billion under management. Of that, $29.9 billion is invested in various hedge funds, up nearly 50 percent from the previous year, allowing AQR to climb to No. 7 from 14th place. AQR says that in 2013 it had inflows to strategies like managed futures and Delta, as well as to new strategies such as its Style Premia Alternative Fund.

Lone Pine and Viking were buoyed by long-only funds. Lone Pine’s long-only funds account for $17 billion of the Greenwich firm’s $29 billion in total assets; its long-short fund has $18 billion. Last year, in a rising market, the long-only funds climbed 32 percent, on average, boosting total assets under management by performance alone. At the end of 2013, Lone Pine did not return capital from its long-short funds, which it has done frequently over the years. In 2014 the firm increased assets further by taking in $2 billion for Lone Tamarack, its first new long-short equity fund in more than a decade.

New York–based Viking’s long-only funds accounted for $7.5 billion of the firm’s $27.1 billion in assets at the start of the year. Last year the Viking Long Fund, which launched in 2009, surged 38.4 percent, while Viking Global Equities, its long-short fund, rose 22.6 percent. As a result, in early 2013 the firm closed VLF to new investments, several months after closing VGE.

Despite the debate over what critics pejoratively refer to as asset gatherers, some strategies see size as an advantage. No. 36 BlueMountain Capital Management, which mostly invests in credit instruments like credit default swaps, corporate and convertible bonds, loans, collateralized debt obligations and other asset-backed securities, plus some mezzanine lending, grew hedge fund assets from $5.6 billion in January 2011 to $14.4 billion at the end of 2013. Stephen Siderow, who co-founded the New York firm with Andrew Feldstein, told Alpha earlier this year that scale gives a firm negotiating power. Otherwise we wouldn’t be able to look at a lot of investment opportunities, he said.

No. 14–ranked Winton Capital Management, a London-based CTA, or commodity trading adviser, firm, has been raising money at a steady clip since 2003, but demand grew after 2010, a spokesman writes in an e-mail message to Alpha, and assets mushroomed by 70 percent in the past two years. The managed-futures industry posted strong results in 2008, and Winton attracted institutions seeking to diversify their portfolios; they were also drawn by the liquidity of the strategy. Winton used its management fees to expand its research team, and the firm’s size provides advantages in trading in commodity markets such as cocoa.

An executive at one big hedge fund firm stresses that size is a function of the opportunities in the market. For example, the ability of William Ackman’s Pershing Square Capital Management, headquartered in New York, to put up $4 billion to invest in Irvine, California–based Botox maker Allergan provides a lot of muscle for its M&A partner, Quebec-based Valeant Pharmaceuticals International, in their joint takeover bid. However, activists that target small-cap stocks, such as Starboard Value in New York, don’t need such great size. Starboard manages less than $2 billion — a lot of money for its kind of activism. It’s a balancing act, the executive says. You want to achieve the best returns possible.

Judith Posnikoff, a founding partner of Pacific Alternative Asset Management Co. an Irvine-based fund-of-funds firm, believes the sweet spot for long-short equity may be in the $750 million to $2 billion range. Other strategies need to be larger to gain a competitive advantage. Statistical arbitrage needs a heavy infrastructure, while distressed needs to employ legal teams, she says.

In an April 2013 investor letter, Baupost’s Seth Klarman discussed pluses and minuses of size. Baupost, which falls to No. 11 from No. 7, mostly hunts for deep value in distressed debt, commercial real estate and overlooked, neglected or complex securities. Klarman noted that asset size can offer benefits. We are able to triple- or quadruple-team the most complex and fast-moving opportunities, have sufficient staff to analyze an industry or geographic opportunity that a smaller competitor couldn’t pursue, negotiate with limited or no competition for sizeable transactions in public and private markets from urgent sellers, and staff an operations team to handle even the most complex investments without missing a beat, he wrote.

But size can limit the firm’s ability to be nimble, while rendering smaller positions less impactful on the overall result, he wrote. Greater size is a disadvantage in strongly rising markets.

Given that, it wasn’t surprising last year when Baupost returned money to investors for only the second time in its 32-year history. Klarman explained that unless investment opportunities dramatically increased, the intention was to better match our assets under management with the opportunity set we see for new investments.

He’s not alone. Appaloosa founder David Tepper is a serial returner of capital. The firm has given back approximately $10 billion in its 21-year history — $5 billion since 2010. Tepper’s goal is to keep the firm’s size at a level he deems optimal.

Third Point’s Daniel Loeb announced last year that he planned to return money and said he was doing it to moderate asset growth. Our increased size is primarily a result of a net annualized return since January 1, 2009, of 24 percent to investors in the flagship Partners fund and 29 percent in our slightly levered Ultra fund, which have led growth in the capital base since our initial close to new inflows in mid-2011, he told clients.

Jana Partners followed, closing its Nirvana Fund on May 1 and adding that it might close the flagship Jana Partners fund sometime in the future. Sources say no decision has been made.

Some firms that are struggling find raising money uncomfortable. In a July 2013 letter to clients, Convexity, the Boston hedge fund firm co-founded by former Harvard University endowment chief Jack Meyer, said its main fund lagged its benchmarks by 167 basis points for the 12 months ended June 30, 2013. While the second quarter was a disappointment, the more important issue is that we have failed to add value over the past 18 months, the firm’s managers wrote. Convexity received $35 million in new money in the second quarter but saw $566 million leave, leading the firm to close the fund to new investors until our performance improves. At the start of 2014, the firm had $14 billion, down from $14.4 billion a year ago, and it slips to No. 37 from No. 30.

What do investors really think about size? London based data tracker Preqin asked investors what size funds they were looking to invest in during 2014: Some 57 percent singled out those with $1 billion to $4.9 billion in assets and 52 percent cited funds managing $100 million to $499 million. The one category (of five) that appeared least: firms with $5 billion or more. This indicates that investors are at least in principle willing to work with smaller managers, Preqin noted.