For Some Managers, Small is Beautiful

For investors looking to hire outperforming managers, small firms have the upper hand.

100x102-juliesegal2-2.jpg
Imogen Rose-Smith / Julie Segal

Imogen Rose-Smith / Julie Segal

Even though experts predict that we’re going to see big funds hire and fire managers in dizzying numbers after the damage wrought by 2008’s bear market, investors are still sitting on their hands. Endowments, foundations and pension funds are sifting through the wreckage of their portfolios last year, trying to pinpoint whether their managers fared poorly in 2008 because of events outside their control or whether they just made bad investment decisions.

One thing for sure — judging from the flurry of responses Institutional Investor received to my story “Study Suggests Small Managers Are Better for Large Investors” — is that investors desperately want clues to what managers will perform in the future. And why.

Small managers, clearly, have the upper hand. John McCareins, investment program manager for Northern Trust Global Advisors, the Chicago firm that conducted the study showing small managers’ outperformance, elaborated on a few trends worth noting. First, the restructuring among commercial banks, investment banks, and larger asset managers will create more start-ups and a new crop of emerging managers.

“The sources of new managers have been dictated by the availability of capital to finance these operations, investment teams that are willing to strike out on their own and demand from institutional investors,” says McCareins. He believes that while capital is more expensive than in previous years, there is still a lot of liquidity on the sidelines to finance new investment shops.

There also are dozens of people who just want to run money and break away from the big firms that are increasingly subject to government scrutiny. But McCareins is on the fence when it comes to the demand side of the equation. Like me, he says investors are allocating assets to new strategies, but they’re still largely “sorting through the rubble of 2008” and asking questions like, ‘did I have my asset allocation right?’

Although many big firms provide good returns, the looming question is why investors stick with them for the majority of their portfolios. “It boils down to reputation,” says McCareins. “It feels better to hire a brand name manager that all your peers have hired. Everybody looks like an idiot if it doesn’t work, not just you. There’s more career risk in breaking away from the herd.”

Emerging managers also don’t have the marketing and distribution budgets to get in front of plan sponsors. Even the mega-merger between BlackRock and Barclays Global Investors — both have more than $1 trillion each — is being justified in terms of the scale the merged firms can bring to marketing.

After the BlackRock/BGI deal, most pundits are expecting a flurry of more mega deals later in 2009 and 2010, but there is plenty of dealmaking among specialized managers as well. Paul Greenwood, co-founder and managing director of Northern Lights Ventures, a private equity firm that invests solely in small managers, says, “We’re a huge believer in the virtues of boutique investing.” Northern Lights takes a minority interest in firms around the $500 million size.

Greenwood agrees that investors still lean toward the big firms. “It’s unfortunate, because a lot of the best investment managers are off the beaten path. If clients were really interested in optimizing their returns, they would be focused on smaller managers earlier in their life cycle when the client can drive better fee arrangements and other deals.”

Related