Emerging managers substantially outperform other hedge fund managers because they are more nimble and can invest in ideas that are often overlooked by large fund managers. Small fund managers are able to take more concentrated positions, and they also have better access to the historically higher returns of small-cap stocks.
We believe that older hedge funds can retain high levels of performance by 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.
The Unique Advantages of Emerging Managers
Innovation is also a significant reason for the outperformance of emerging hedge funds. This argument is intuitively appealing because managers frustrated by the limits of established funds often start new funds. However, the innovation argument is also a classic case of diminishing returns.
An emerging fund begins with a new idea that yields higher profits. The success of the hedge fund causes it to become larger and eventually correct the market inefficiencies that were the source of the fund's excess returns. A hedge fund can try to avoid this fate by remaining small, but its success will still spawn imitators in many cases
Emerging funds are more responsive to current market conditions than more mature funds. Research from eVestment Alliance shows that younger hedge funds outperformed tenured funds before, during, and after the 2008 financial crisis. An obvious explanation for this is that new funds pay more attention to whatever current conditions exist.
Realizing the Return
There are several other reasons for the outperformance of emerging fund managers. New hedge fund managers are generally more committed and have fewer conflicts of interest. New funds must outperform to survive, so their managers have a greater incentive to succeed.
If established funds are not trying to beat the market anymore, then what are they trying to do? In most cases, a benchmark is developed once an approach is sufficiently mature. It then becomes imperative to avoid tracking error rather than produce higher returns. Established fund managers are more likely to become closet indexers.
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 is crucial.
Ashton Global helps investors to realize the higher returns of emerging managers by matching them with high-quality portfolio managers with niche investment ideas. We focus on risk-adjusted returns, so we usually recommend investing in several funds to diversify risks.
The relatively high minimum investment requirements of hedge funds make diversification difficult even for most wealthy individuals. Emerging fund managers are therefore a unique source of alpha for institutional investors. Contact us to learn more.