Hedge Funds Hit Limits

When it comes to hedge fund returns, size matters.

So far this year, hedge funds have returned an average of 2.42%, according to data compiled by Standard & Poor's. That's below the S&P 500's return of 3.76% and, barring a huge December, sets the industry up for its second straight year of disappointing returns.

Numerous explanations are given for the problem, including sluggish markets and too many managers chasing too few strategies. But one overlooked factor is that funds are getting larger.

The 50 largest hedge funds together control $385 billion of assets, according to a list published by Alpha magazine. That's more than a third of the total asset base for an industry estimated at $1 trillion. When one considers that there are about 8,000 to 9,000 managers, the power concentrated at the biggest shops can't be underemphasized.

"The big hedge funds are getting bigger," says George Lucaci, managing director at Channel Capital, which operates the HedgeFund.net database.

The trend toward concentration has been in place for several years. In December 2000, there were only seven hedge funds with more than $5 billion under management, according to InfoVest and HedgeFund Intelligence. The number rose to 42 by December of last year. During the same period, funds with $1 billion to $5 billion in assets grew from 46 to 193.

Several titanic fund shops continue to see assets surge. Citadel Investment Group, for instance, had $9.5 billion in assets under management last year. The hoard is up 15.7% to $11 billion this year, according to Alpha. Farallon Capital Management was the biggest fund this year with $12.5 billion in assets, a 27% increase from 2004.

Some believe the biggest funds' growth rate is impacting returns across the industry. "There is an inverse correlation between size and performance," says Mohnish Pabrai of Pabrai Investment Funds, a private investment partnership based in Lake Forest, Calif.