The Advantages of Small Investment Funds
Emerging managers substantially outperform more mature hedge funds because they are more nimble and can invest in ideas that are often overlooked by larger firms. According to a study by Preqin, emerging funds (less than three years old) earned an average of 12.2% versus the overall hedge fund industry’s return of 7.7% annually over a recent five year time-frame.
Gao, Haight, and Yin argued in a 2018 paper that older hedge funds can retain high levels of performance by simply remaining small. The most obvious way to stay small is to close the fund to new investors once it reaches a certain size. That makes it more important to invest in emerging hedge funds before the top performers are closed to new investors due to capacity constraints.
The Unique Advantages of Emerging Managers
Innovation is a significant reason for the outperformance of emerging manager hedge funds. Portfolio managers frustrated by the limits and bureaucracy of established funds often start new ventures with interesting and unique ideas. Many of these investment strategies, though profitable, may be overlooked by larger firms due to complexity, regulatory considerations, or simply because they may be “too small to move the needle”.
Unfortunately, the innovation argument can also lead to diminishing returns. An emerging fund begins with a new idea that yields higher profits. The success of the hedge fund causes it to become so large that it can no longer exploit the inefficiencies that were the source of the fund’s excess returns. A hedge fund can try to avoid this fate by remaining small, but success will also spawn imitators in many strategies if the returns are high.
“It is imperative that new managers have a clear understanding of their strategies, and be able to articulate to investors the AUM at which performance could likely erode.”
Emerging Managers Outperformed During the Financial Crisis
Research from eVestment Alliance shows that younger hedge funds outperformed tenured funds before, during, and after the 2008 financial crisis. We believe that new funds pay more attention to market conditions due to the high level of employee ownership and fewer distractions, since smaller managers tend to focus on one or two core strategies. Many of our managers also have more flexible mandates than traditional funds, and are able raise cash allocations or hedge the portfolio to mitigate risks.
New hedge fund managers are generally more committed to the fund’s success and have more “skin in the game” than managers in large investment firms. The necessity for an emerging manager to get to critical mass quickly (roughly $80 million to $100 million of AUM) provides a huge incentive to generate alpha while protecting against drawdowns. In our experience, many mature funds are more focused on avoiding tracking error (versus a benchmark) than producing high returns for investors.
“Emerging hedge fund managers are generally more committed and have fewer conflicts of interest than established hedge fund managers.”
Why Have Emerging Managers Been Overlooked?
Although emerging hedge fund managers produce higher returns, this outperformance comes with greater idiosyncratic risk. Individual emerging funds are more likely to fail because they are smaller and use untested strategies, so manager selection and diversification is critical.
Emerging managers also tend to have niche strategies and limited capacities which may be too small to meaningfully improve the overall portfolio return for a large endowment or pension fund. Investors can also be reluctant to invest in emerging managers due to headline risk and concentration risk.
The Outlook Remains Strong for Institutional-Quality Emerging Managers
We recommend that institutional clients invest via an emerging manager program, or manager platform, to gain scale and diversity. Ashton Global uses a global network across a variety of industries and disciplines to source undiscovered investment managers that are capable of generating sustainable alpha over time.
Our process begins with screening methods to identify managers that are well-connected in emerging and frontier markets, with interesting pipelines of both public and private investment opportunities. Once we identify potential managers that offer unique strategies, we develop these managers with co-investments or smaller mandates to prove out the investment thesis, and to help them build a track record.
Please contact us at +1 212 514 8953 or click here to learn more about our emerging manager platform.