Hedge Funds Hit Limits

"You can't do a lot of small trades with a large hedge fund group," says Marc Freed, an analyst at Lyster Watson, a fund of funds that works with smaller shops.

Pabrai illustrates his point by comparing two funds: a small one with $50 million in assets and a large one with $1 billion under management. He assumes that both run a concentrated portfolio of 10 positions. The small fund can make $5 million bets on a universe of assets that include micro-cap companies worth less than $50 million, he says. But the larger fund, whose minimum investment is probably about $100 million, must make bets in companies whose market capitalization exceeds $1 billion.

"The larger hedge fund is forced to invest in companies with a larger market cap," says Pabrai. "As you get more capital to manage, the numbers of opportunities in which you can invest shrink."

"Ten years ago, the Citadel and the like were much smaller and their returns were much better," Pabrai says. "In the beginning, all Citadel did was convertible arbitrage. Today, there is too much capital chasing returns in this strategy and it is very hard to make money."

If big shops are growing bigger, it is because institutional investors perceive them as a safer alternative than newer or smaller ones, even if the trade off is often a lower performance.

"What has changed in the past two years is that there is a lot more demand for hedge funds from the pension fund community and they are much more reliant on consultants than foundations and endowments," says Freed.

"Consultants have a strong preference for larger organization because they feel they are more likely to stay in business. The reasoning is: we don't get good returns. OK. But we don't want to get the blowups."