Brevan Howard Asset Management LP Headquarters...A security guard stands outside 55 Baker Street, the building housing the offices of Brevan Howard Asset Management LP, in London, U.K., on Friday, April 15, 2011. Brevan Howard Asset Management LP hired three Goldman Sachs Group Inc. employees to trade for its biggest hedge fund, according to a person briefed on the matter. Photographer: Chris Ratcliffe/Bloomberg
Brevan Howard HQ, Baker St, London © Bloomberg

The shock is not that hedge funds are suffering; it is that it has taken this long for it to happen. Brevan Howard, once one of the world’s largest, is rapidly shrinking. Assets under management have reportedly halved in two years, and now stand at $19bn.

There are clear reasons why any active investment fund charging a large performance fee (20 per cent of profit is the standard hedge fund cut, and Brevan’s) and fixed management fee (2 per cents of assets) should struggle to maintain good performance as it grows. First, as assets grow, the number of places it can invest without distorting the markets shrinks. Second, at some point that 2 per cent starts to be a big number. Keeping the management fees rolling in — with performance just good enough to retain assets — becomes a more attractive approach than trying to consistently beat a benchmark.

Over the past three years, the smallest funds (under $100m) beat those with over $1bn — returning around 5 per cent annually against 4.6 per cent, according to Preqin. The gap is particularly pronounced in the year to July, during which the biggest funds fell while the tiddlers gained more than 2 per cent. There is also evidence that one should stick with the smallest funds in times of market crisis, according to a Cass Business School study.

Quant funds seem to have an easier time scaling their investment strategies as assets increase. In the first quarter of this year Commodity Trading Advisers, a type of quant, had inflows of $13.7bn. Overall, though, hedge funds had an even bigger outflow.

The core problem of hedge funds as an asset class is quite simple: having a management fee that stays fixed this high as assets under management change makes little sense. Any fund whose costs were rising with the amount managed would be sclerotic. As those costs are relatively fixed, funds should be paid proportionally less as they grow to cover them. Twenty per cent may be outrageous, but two per cent is dangerous.

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