How AUM Growth Degrades Manager Portfolios

Asset Growth and Performance

The question of growth and its effect on performance has perplexed investors since the dawn of active money management. When a manager grows their assets, do they become victims of their own success and lose the very abilities by which they grew? Do they need to shift investment styles, or give up taking similar levels of risk, jeopardizing future performance?

We speak to hundreds of investors and hedge fund managers and understand that each case varies from the next. However, having analyzed tons of data on hedge fund managers, we can begin to draw some general conclusions about the industry and how growth affects the average manager.

Three Levers Managers Can Pull

In an equities-heavy portfolio, there are three key aspects that are affected by increasing AUM. They are the portfolio’s position count (manager might deploy the newly raised capital into new ideas), market capitalization (manager might want to invest in larger capitalization securities), and / or liquidity (the percentage of portfolio the manager can easily liquidate will drop). These can change in isolation or altogether.

As we have seen in our research on public ownership of the Tiger Cubs, there is beautiful evidence to support this theory. As the total AUM managed by the group of hedge funds with links to Tiger Management grew and position counts remained relatively stable, they moved up the market cap spectrum but not enough to offset the drop in liquidity:

Our findings for the aggregate industry

When we analyzed the aggregated holdings of hedge funds based on public ownership, we saw similar trends. For this, as well as many other studies, we used the Novus Hedge Fund Universe (HFU) portfolio made up of over 1,000 manager portfolios, weighted by reported market value. As the long market value of hedge fund holdings tipped $2T, the number of securities remained relatively stable while weighted market capitalization increased. This increase in market cap was not enough to offset the decline in overall liquidity.

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Individual Funds

It’s interesting to see how these concepts relate to individual funds. Breaking the data down by fund, we see how asset growth works on a more granular level. Of the 917 hedge funds we tracked in 2009, 723 are still alive today. Of those, 387, or 45%, grew their reported assets by more than 30% in that time. 57% of managers moved up the market cap spectrum and 24% meaningfully increased portfolio position counts. Relatively few (15%) experienced drops in liquidity of 30% or more in those years, and 42% had experienced no meaningful changes to their portfolios.

However, looking at those managers that grew their AUM by 30% or more in isolation changes the picture drastically. A whopping 70% of growing managers moved up the market capitalization spectrum significantly. Over 37% increased their positions counts (decreasing concentration), and 9% had a drop in liquidity. Only 17% of managers experiencing significant AUM growth did not have meaningful changes in any of those three areas (compared to 42% in hedge funds overall).

This means that the preferred method to deploy new capital is allocating it to higher capitalization stocks, followed by increasing the number of investments in the portfolio. Managers have not been willing to sacrifice liquidity, but liquidity changed without their control nevertheless.

You might wonder how liquidity dropped in aggregate even though numbers look so healthy on an individual basis. Here is a critical nuance in calculating liquidity figures: when calculated on an individual basis, as you see in these later charts, the liquidity numbers are fine. Many managers will tell you that their liquidity is as healthy as ever, and they’d be right. Unless, that is, they consider all the other hedge funds invested in their stocks. The aggregate liquidity is what really matters during times of market stress, and as we have seen from our earlier analysis, that has been declining considerably.

Conclusion

We can clearly see from the data that asset growth brings about critical changes in the portfolio characteristics of managers. But how does this relate to performance? Preliminary analysis into our skill set data is beginning to reveal some relationships, and a very real effect of asset growth on manager skill. But that’s a topic for another blog post. Stay tuned.

For more information, check out our research paper, “How AUM Growth Inhibits Performance.”