Like real estate, hedge funds all about location, location and location

One of the frustrations experienced by hedge fund managers in out-of the-way locales is that global investors seem to ignore their alpha-generating potential until there is a big move in some kind of underlying beta.  Take Canada, for example.  Managers in that country have long argued that you need feet on the ground to fully exploit most opportunities.  American managers, they are apt to say, can’t just fly in for one day meetings and expect to know the lay of the land.  These foreign invaders are only attracted to the largest domestic investment opportunities, the argument went, not the mid-cap “sweet spot”.  But for the most part, global investors stayed away anyway.

But when oil passed $100, guess what happened.  Canada’s hedge fund alpha story suddenly resonated with investors even though long-only energy beta was what those investors were really seeking.  Last fall, the head of the Canadian Chapter of AIMA acknowledged this situation but essentially said Canadians would take the additional dollars anyway and worry about investors’ specific motivations later (see related posting).

This scenario was undoubtedly played out around the world as geographically-dispersed hedge funds tried to convince investors that local presence was actually really important.

Now, they may be vindicated.  A new paper due to be published in the Review of Financial Studies finds that Asian hedge funds with a local address actual do perform better than those without one.  And guess what; they perform substantially better in less developed, informationally-inefficient markets (surprise, surprise).  The chart below from the paper shows how a portfolio of locally-based hedge funds (solid line) has produced more cumulative alpha than a portfolio of non-locally-based funds. [Click to enlarge]

But despite this outperformance, author Melvyn Teo finds that foreign funds (mainly from the US and UK) are still more able to charge higher fees and establish longer lock-ups than their predominently smaller, locally-based cousins.  Teo puts it bluntly:

…distant funds, by being close to their investor base in developed markets (large institutions, pension funds, and endowments), trade investment performance for better access to capital.

Teo examined Asian funds partly because the distance and time zone changes to the US and UK were substantial.  Perhaps to the chagrin of the Canucks, he suggests that proximity may in fact mitigate this disparity.

This is music to the ears of funds of funds that invest in Asian managers, says Teo.  The outperformance of these local managers is more than enough to justify the extra layer of fees.  In addition, he warns:

The alternative for individual investors is to invest directly in the underlying hedge funds themselves.   However, given the importance that we have shown of investing in nearby funds, the due diligence and monitoring costs involved may be prohibitive for individual investors who lack the economies of scale.

So maybe geography counts for something after all.  With the legions of institutional investors flocking to a smaller and smaller number of US and UK-based mega-funds, this is a fact that probably shouldn’t be overlooked.

Late-breaking related article:Emerging-market hedge funds gaining traction” (August 20, 2008, Investment News)

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