The relation between hedge fund size and risk

Abstract

In their quest for safety, investors have been willing to forego the higher returns that could be achieved with investing in smaller hedge funds for the perceived greater safety of larger funds. Thus, hedge fund investors have flocked to larger hedge funds in the past, and are currently doing so to an even greater extent. This article provides evidence suggesting that large funds may actually be riskier than smaller funds. Specifically, we find that the largest hedge funds are more likely than smaller hedge funds to either cease operations or restrict investor liquidity. Therefore, we believe that investors’ current focus on larger hedge funds may be misplaced, and that institutional investors who focus on larger hedge funds may not see the expected portfolio benefits of uncorrelated, absolute returns and a reduction in overall volatility.