Since the financial crisis, many investors have been shying away from fledgling hedge funds. According to a 2011 study by Preqin, only 24 percent of private sector pension plans were willing to invest with emerging hedge funds, down from 46 percent in 2009. Instead of trying new managers, investors have been gravitating to a few big funds with long track records. Only 3.9 percent of the 10,000 single-manager hedge funds account for 60 percent of the assets, according to PerTrac.
But the move into giant funds could result in lower returns. Studying performance for the 15 years ending in 2010, PerTrac found that young funds delivered the best results. For the period, funds that were less than two years old returned 16.2 percent annually, while funds that were two to four years old returned 12.2 percent, and those with track records of more than four years returned 10.9 percent. The young funds delivered extra returns while recording lower risk as measured by standard deviation. In addition, small funds with less than $100 million in assets outperformed larger funds by a wide margin.
Analysts argue that emerging managers have big advantages because they can trade more nimbly. While giant portfolios may be forced to stick with blue-chip stocks and other holdings that can be traded in large qualities, start-up funds can use small caps and less liquid choices. Big funds tend to spread their bets, following more than one strategy. In contrast, emerging funds stick to one approach. “Because young portfolios tend to focus on what they do best, hedge funds often deliver their best returns during their first years,” says Antoine Rolland, CEO of Paris-based NewAlpha Asset Management, which manages $250 million that is invested in emerging managers.
Emerging managers may get better returns because they are hungrier, says Nadia Papagiannis, alternative investment strategist for Morningstar. To attract assets, young funds take big risks in order to deliver outsized returns.
The aggressiveness of small funds may be reinforced by the traditional fee structure, which includes 2 percent annual management fees and performance fees equal to 20 percent of profits. Large funds can cover their costs by collecting annual management fees, says Papagiannis. “To survive, emerging funds need to take risks so that they can earn incentive fees,” she says.
Seeking better returns and more diversification, some pensions have begun targeting emerging funds. The Illinois Teachers’ Retirement System recently invested $40 million in two emerging funds. California Public Employees’ Retirement System (CalPERS) put $500 million in customized funds of emerging hedge funds. In addition, CalPERS has begun seeding hedge funds, providing early-stage investments that can help emerging managers build profitable businesses. The pension recently invested $100 million in seed money with Breton Hill Capital, a Toronto-based global macro hedge fund with investments in equities, commodities, and currencies.
Some pensions prefer seeding because it can produce outsized returns. In a typical deal, an investor puts $20 million to $80 million into an emerging fund. The investor may receive equity or an agreement to take 20 percent to 30 percent of a fund’s revenues for a fixed period, such as eight years. Two years ago NewAlpha Asset Management provided $40 million in seed money to Armored Wolf, a global macro outfit headed by John Brynjolfsson, who was the former manager of PIMCO’s real return funds. “Despite the manager’s talents and track record, it was difficult for him to put together the first $100 million,” says Antoine Rolland of NewAlpha.
With the cash in hand, the emerging fund was able to attract other investors. Now the manager has about $1 billion in assets.
Some managers say that the opportunities for seeding are particularly abundant these days. With the Volcker Rule causing investment banks to trim their proprietary trading desks, successful portfolio managers are seeking to start their own hedge funds. But the emerging managers face increasing competition for funds at a time when many institutions are wary of betting on startups.