Pick young, small hedge funds for better returns?

If you face a choice between two hedge funds with equally attractive performance records, you should pick the younger, smaller fund.

At least, that’s what I took away from “Hedge Fund Performance Persistence: A New Approach,” an article by Nicole M. Boyson, an assistant professor of finance at Northeastern University, in the Nov./Dec. 2008 issue of the Financial Analysts Journal (CFA Institute membership or other payment required for online access).

Here’s how Boyson put it: “by selecting funds on the basis of fund age and fund size in addition to past performance, investors can substantially improve the likelihood of superior performance over a selection process based on past performance alone.”

Funds with good track records may eventually underperform, she wrote, because “At some point, these funds will grow so large that the fund manager’s skills will be spread too thin and/or the fund’s trades will have a larger price impact and higher transaction costs than previously–both of which compromise the fund’s performance.”

Boyson found that “A portfolio of young, small, good past performers outperformed a portfolio of old, large, poor past performers by nearly 10 percentage points per year.”

I wish she’d shared how the performance of the young, small, good performers compared to the good performers among the old, large funds.