Does market-beating performance disappear as an asset manager gets big? This is a crucial question for investors and for the finance industry.
Most introductory finance classes, or personal finance tutorials, start with an explanation of compound interest. They show how even a modest sum, growing over time at a constant rate, will balloon to incredible size. This definitely works for stocks — or at least it has so far. If you put your money in the U.S. stock market any time in the past century and then just waited a few decades, you reaped big gains.
But this simple math can yield some truly eye-popping projections when you combine it with the notion of market-beating returns, or alpha. Suppose that instead of the 8 percent to 10 percent average return of the stock market, you could get the 30 percent return reportedly achieved by Two Sigma Investments’ Compass Enhanced fund — one of the hedge fund industry’s top performers — from 2005-2014. You would more than double your money every three years! If you got that kind of return for three decades, you’d have more than 2,500 times the amount you started with. That’s almost unimaginable wealth, even for an average earner.
But there’s a catch here. If alpha drops as assets increase, the returns don’t compound at those dizzying rates. Suppose that a hedge fund can get 30 percent every year, but only on assets of $1 billion. If it tries to scale up to $10 billion, the alpha will go way down. So it keeps its assets at the $1 billion level by distributing its $300 million in profits to its investors every year. Those investors then invest the $300 million in the broader stock market, or in the average hedge fund (which does slightly worse than the broader stock market).
In this hypothetical example, the investors aren’t earning compound interest of 30 percent — they’re earning much less. To see how this works, let’s do a little simulation. Suppose I start out with $1 million, and invest it in a hedge fund called Magic Alpha. Magic Alpha won’t let me invest more than $1 million, but it earns 30 percent every year after fees, and hands me a $300,000 check every January. All of my money that isn’t in Magic Alpha is in the stock market, which earns a reliable 8 percent a year. Here’s what my money looks like: