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.

"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."

With large chunks of pensions' assets at risk, big hedge funds tend to manage money more conservatively. It makes sense when one considers the industry's fee structure, which generally charges 1.5% on assets and 20% on returns. A $5 billion hedge fund manager is more likely to be satisfied with a 1.5% management fee on assets than is one managing $50 million.

The dynamic could also be bringing down the industry's overall performance.

"It's very difficult to find funds with 25% returns. Hedge funds are more interested in running a business than running a fund," says Paul Zummo, head of JP Morgan Alternative Asset Management, the fund-of-funds arm of the bank. "The fact that pensions demand consistency of returns is part of the problem." As a result, Zummo says, leading hedge funds have increasingly rolled out multistrategy funds and are taking less risk exposure.

Pabrai predicts that large funds are not going to do as well than in the past. "They have marketed themselves as vehicles that do not lose money because they're hedged. That is a false statement. Even if they hedge perfectly, they charge fees and they have to perform over the cost of those fees in order to look good," he says.

Some say that if hedge fund performance doesn't turn around, the industry's glory days are behind it.

"I will be very surprised if 10 years from now, hedge funds have the size they have today or are still the cocktail party conversation. All of that will die down in the next few years," says Pabrai.