Do Hedge Fund Returns Fall as Their Assets Rise?

One of the more counterintutive aspects of the current boom in alternative investments is that the biggest shops, be they private equity or hedge funds, seem to get the best returns. David Leonhardt has noticed this too, although it seems he can't quite believe it:

Thanks to their incredible performance, the biggest funds have grown far bigger in recent years. The 100 largest firms in the world managed $1 trillion at the end of last year, or 69 percent of all the assets in hedge funds, according to Alpha. At the end of 2003, the top 100 had less than $500 billion, or only 54 percent of total hedge fund investments.
“The best performance is coming from the largest funds,” said Christy Wood, who oversees equities investments for the California Public Employees’ Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.
But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years won’t be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments.

The underlying concept behind Leohardt's final sentence here is that there's a finite pool of possible arbitrages (or alpha, if you will). The more hedge funds and the more money that's chasing that alpha, the less there is to go round.

The thing is, I've seen no empirical evidence to that effect. Indeed, the very fact that bigger hedge funds have higher returns than smaller hedge funds would seem to be something of a counterexample. To be sure, there are lots of profitable trades out there which are only accessible to smaller investors, especially in the world of small-cap stocks. But clearly there are also lots of profitable trades out there which are only accessible to larger investors.

The total amount of money invested in hedge funds is still dwarfed by the amount of money in mutual funds and other long-only investment portfolios. The time may come when hedge funds run out of things to invest in, but I don't see it happening for a while.