A Brighter Outlook for Emerging Hedge Fund Managers in 2012

March 13, 2012 − by unityadmin − in News

According to AIMA in its First Quarter Journal (March 2012), we are seeing some positive momentum change in the outlook for 2012. Reflecting on 2011 and making predictions for 2012, the general consensus seems to be that 2011 was not a great year for hedge funds; in fact it was the second worst year in history, after 2008.

The outlook for 2012, however, seems to point towards the view that the only way is up and one of the key areas of focus in the investment industry is potential in the emerging fund manager arena. A study by the conference facilitator GAIM USA came to the conclusion that emerging fund managers are expecting to make gains of more than 10% in 2012.

One of the most widely read industry studies of 2011 from research firm Pertrac, produced evidence that smaller hedge funds have been outperforming mid and larger size funds. Using a sample of 7,157 hedge funds, Pertrac found that funds managing less than $100m each produced 360 basis points of annualised outperformance over funds managing more than $500m in the last 15 years. In addition to size, funds with less than two years of operation experience have outperformed funds with more than four years experience by 526 basis points in the last 15 years.

This study did not take into account the funds which closed however, creating a ‘survivorship bias’ where the financial records of funds which closed are omitted. It is therefore perhaps more useful to examine the attributes of emerging managers which make them so attractive.

 

Why Emerging Fund Managers?

Emerging fund managers are at the start of their life cycle and are often smaller in size. Agecroft, the alternative investment marketing firm, suggests that small to mid-sized fund managers will receive greater investment flows this year. This is attributed to investor sentiment that larger hedge funds have accumulated too many assets, which can dilute their alpha over such a large base of assets. Furthermore, the larger bets which must be made on individual securities can increase the investment risk of a fund.

The nimbleness and lack of bureaucracy that smaller fund managers benefit from is seen as an attractive alternative to perhaps unwieldy, well established funds. Smaller, newer funds use investment strategies where the manager unlocks value using data which is less trafficked and which is deemed to be too insignificant to report in the media. This agility also makes it harder for rivals to pre-empt the actions of a smaller manager. In addition to this, when smaller funds invest where excellent risk-reward potential exists, the potential increase in assets will have a much greater effect on the manager’s portfolio than it would in a larger manager’s.

Hedge funds which have grown to be very large often find it difficult to recreate the success of earlier years. Start up funds often possess greater liquidity than large, established funds. They can thus move in and out of positions with greater ease and can allocate their funds more easily during times of volatility. Furthermore, star investment managers have a tendency to leave the fund in order to start up their own fund.  Many Institutional Investors are starting to recognise the strategic advantages of targeting skilled fund managers with experience in large corporates, who are now starting their own fund using innovative strategies.

These investors will look towards fund managers with a proven track record, who manage smaller, nimbler funds. One appealing attraction is that it is easier for investors to access a smaller fund manager and learn more about their trading strategy, upcoming opportunities and thus make more informed decisions. Another important reason is that investors often choose to invest in emerging managers is the ‘skin in the game’ factor. This means that hedge fund managers often start out with a significant personal investment in their fund, thus they will work as hard as possible to avoid losing it.

Based on recent anecdotal experience, we expect to see a trend in 2012 and beyond as the Hedge Fund industry continues to mature, whereby a funds of funds or institutional allocator invests in emerging manager funds who compete on differentiated, innovative strategies.  The seemingly never ending proliferation of international regulations are presenting ever increasing constraints on the traditional business of investment banks and coupled with the aforementioned conditions, are creating an environment where more and more talented traders are looking to create their own hedge fund businesses.

 

Overcoming Challenges for Start Up Managers

These new shops which seem to be long on talent and short on capital are garnering greater attention from larger Institutional Investors. However, one must strike a note of caution in that it remains to be seen whether this recent trend will significantly impact the large hedge funds such as a GLG, Brevan-Howard, Man Group or a Winton Capital.

In order for that to happen, emerging managers will need to address not just the greater potential for “Alpha” but also as importantly, the operational due diligence requirements which are mandatory for Institutional Investors to satisfy in order to invest. The new shops are boutique houses, so their proposition tends to be somewhat more vulnerable to business risk, operational risk, key person risk, etc.

In-depth checking of the I.T. platforms, back office and business operations are a fundamental pre-requisite for Institutional Investors prior to allocation. However, to provide such institutional grade infrastructure is expensive to address and to attempt to do so in-house in the earliest days of creating a new business can not only be both cost prohibitive but also potentially fatal, in that one might get distracted from the core objective of managing the markets and implementing one’s strategy.

Many of the operational challenges that emerging managers face in order to secure assets can be tackled through outsourcing activities such as the back-office via fund administrators (including the provision of independent NAV calculations). This facilitates investment managers by helping to drive corporate stability and financial viability. Start up managers’ main challenge is to attract investors through performance. Institutional investors need confidence in that performance in order to invest, so they require independent verification of the financial performance indicators. A recent study by Ernst and Young showed that the number one reason that investors prefer to use a 3rd party administrator is to ensure independent valuation and verification of financial figures. The presence of a strong independent administrator increases investor confidence and allows a fund manager to mitigate the risk of error.

Independent valuation also allows a manager to concentrate on pitching to investors, a pitch which is supported by strong back and middle office operations. By freeing up an investment manager’s time, they become more agile and quicker to react to the market. It has been proven that agile asset managers are more likely to outperform the competition, thereby facilitating an increase in financial viability.

 

Conclusion

2012 is the year of the dragon within the Chinese calendar, which is widely considered to be the luckiest year in the Chinese Zodiac. In China dragons traditionally symbolise potent and auspicious powers over the elements in their environment.

Many within the hedge fund industry believe that, whilst we continue to live in a world where market volatility can spike as a result of natural catastrophes, political and social events or market glitches, talented emerging managers with solid operational infrastructure can become investment dragons this year.

These emerging managers can often outperform their more illustrious competitors but it is critical to ensure that the targeted manager has professional business partners such as 3rd party independent administration, custody and other service providers, in order to protect investor interest by provide independent verification of financial figures and safe custody of assets (the two most common themes of all major hedge fund failures over the past twenty years including the “Madoff” affair).

Having investment strength, agility as well as a dash of good luck will be crucial elements of the well balanced, long term investment portfolio capable of withstanding the financial shocks of the future. Talented emerging manager funds with innovative, nimble investment strategies, coupled with solid operational infrastructures should form a key element of that allocation mix.