Hedge funds are netting at least $10 billion a month of inflows this year, but it seems most of the moolah is headed for the eleven-figure, ten zeroes in assets club of managers with $10 billion or more. However, those 800-pound hedge fund gorillas might just have some impudent young monkeys hanging on their backs and showing them up in the performance department.
This Pertrac study found smaller funds outperformed by 5% a year in absolute terms over 11 years. Jorion and Aggarwals’ widely quoted study found emerging managers generate an extra 2.71% in their first two years( and younger managers tend to be smaller) . While this Singapore university study from Melvyn Teo identified 2.75% outperformance, on a risk-adjusted basis. Both of these last two studies insist they have controlled adequately for backfill bias.
Figure 1 Annual Outperformance of Smaller Managers – Selected Studies
Source: AAA staff, created from cited papers
Reasons behind the apparent absolute outperformance are explored in this paper, which says smaller managers are “often be more flexible in their investment approach and better at exploiting niche opportunities, especially in new under-developed and under-researched markets, and be quick to implement investment ideas”. Another paper simply argues that “small firms have greater motivation to produce strong performance.” Skeptics may say that survivorship bias is bigger for smaller funds, and that topic attracted a lot of reader attention in this posting.
Yet what all of these studies seem to ignore can sometimes be far more lucrative than the investment performance: getting a piece of the economics. Seeders feel no shame in quoting Jerry Maguire and saying to start ups “show me the money,” through a share of one or more of the management company, revenues, or fee discounts. Some seeders even end up with all three of these kickers turbocharging their returns, not to mention preferential capacity agreements.
Looking at fee discounts alone, the chart below shows how much a typical seeding 1 and 15 fee structure can enhance returns by, relative to traditional 2 and 20, for a manager making 12% gross a year. Over 10 years the lower fees boost returns by over 30 percentage points.
Source: AAA staff, simulation
The most experienced hedge fund allocators remain so enthused about emerging managers that they have even set up separate ventures dedicated to hunting this fresh talent: over in open minded Amsterdam ,Europe’s biggest pension fund, ABP of the Netherlands has a joint venture called Imqubator that has seeded 10 managers and is about to get another capital infusion from its parent. Meanwhile in London one of the first funds of hedge funds, FRM, has similarly seeded at least 7 managers so far since 2008. With Barney Frank and Chris Dodd chasing top prop traders out of the revolving doors of the banks, the supply of talent should be greater than ever.
It is possible that other pension funds sometimes starting hedge programs for the first time just feel safer with big names ? If pension funds are behind more and more of the flows, then according to this recent AAA posting it’s possible the 800-pound gorillas of the hedge jungle just better at camouflaging their strategies in labels and structures like “portable alpha” and “risk parity” that catch the eye of pension allocators. Smaller managers need to be adept at packaging their strategies into formats such as overlays that can be strapped onto a pension fund with minimal capital outlays. They should also offer investors a menu of both beta, and customized liability, benchmarks to act as reference points for setting performance fees.
This document setting out the California Public Employees’ Retirement System’s policies for its currency overlay programs could be a starting point. Note that CALPERS has also awarded emerging managers mandates to Paamco, 47 degrees North, and Rock Creek: the world’s biggest is setting an example that others may follow.