As the California Public Employees’ Retirement System (CalPERS) begins constructing a fund of emerging hedge fund managers with its consultant Mosaic Investment Advisors, software provider PerTrac Financial Solutions has given us the latest research claiming that younger, smaller hedge funds outperform their larger, more seasoned counterparts.
PerTrac’s managing director Meredith Jones, in “Examination of fund age and size and its impact on hedge fund performance,” combines more than 10 years’ data from the Hedge Fund Research, HedgeFund.net, Altvest and Barclays Global HedgeSource indices and finds that, defined purely as maximised returns, “small funds clearly provide the best investment option.” Funds in the study with less than two years’ track record returned 17.5 per cent annualized, against 14.1 per cent in the mid-range of 2-4 years and 11.84 per cent for funds over four years old.
Focusing the mind
New managers are able to spend most of their time managing assets rather than running a big organisation, the argument goes - and giving up an investment-bank salary to run your family’s money focuses the mind.
“The people we see are really keen,” says Hans Hurschler, head of RMF’s Hedge Fund Ventures vehicle, which has seeded more than 20 start-ups since 2001. “They work those 14-hour days if necessary.”
With less capital to invest, only the best ideas get used, and funds can more nimbly exploit market inefficiencies in more illiquid securities which larger funds have to ignore. Many funds are launched precisely because their managers believe they have found opportunities that are not yet fully-priced by other investors, giving first-mover advantage.
There are sceptics. Rolf Banz, chief investment architect at Pictet Asset Management, responded to Ms Jones’ findings in the Financial Times, citing the survivorship and ex-post selection biases that plague the dataset.
“I would even speculate that the performance of all young funds should, on average, be worse, given the low barriers to entry into the industry and the attrition observed among young funds,” he writes.
“The academic literature is all a bit conflicted because it leaves out a lot of data,” Mr Hurschler agrees. “This is an industry where you can make a lot of money pretty quickly, which attracts a lot of people who just go out of business.”
Ms Jones refers FT Mandate to a recent study by Sam Kirschner, managing director with emerging-manager specialist MayerCap, which puts covered attrition-rate among younger funds at around 8 per cent. (Other commentators put it much higher). She also observes that the problem is really one of participation bias – a lot of upside is concealed as funds move beyond asset-raising and choose not to report.
A 2001 study by CrossBorder Capital – which did adjust for survivorship bias, using the Tass “graveyard” database – found that “the youngest decile funds beat the oldest decile by 970 basis points per annum.” Since then there has been little consensus.
Declining returns
In the same year F R Edwards and M Caglayan argued that larger funds saw declining returns; in 2003 R J Hedges wrote that smaller funds outperform larger funds, but mid-sized funds perform the worst; MM Herzberg and H A Moses found only slightly significant outperformance among smaller funds; A Clark found no differences in performance between fund sizes in any sector (including hedge funds); as did Greg Gregoriou and F Rouah; and in 2005 Manuel Ammann and Patrick Moerth, again using the Tass databases, revealed “a negative relationship between fund sizes and returns,” but also found that “very small funds” underperformed.
“The academic studies are invariably flawed in terms of the data they use,” says Simon Hopkins, chief executive at Fortune Group, which runs an emerging-manager fund. “But enough have appeared to offer some credibility. I am absolutely convinced that managers do best in their first three years and, anecdotally, the industry examples of managers who have lived off their first three years are manifold.”
Tushar Patel, managing director at Hedge Fund Investment Management (HFIM), a recently-launched fund of emerging managers, reckons that many investors ignore the space even though products less than three years old account for 42 per cent of the hedge fund universe.
Big funds of funds are unable to make small allocations whose impact on overall portfolio returns would be insignificant. Selling to institutional investors often means restrictions on untested funds. “Lots of emerging funds are struggling to raise money having hit this ceiling,” says Mr Patel.
Funds launching with less than $50m struggle to get onto the institutional investor radar, says Mr Hurschler, which is why Hedge Fund Ventures prefers “catalysing growth for high-profile start-ups.” The firm doesn’t seed teams without hedge fund pedigree; it subjects them to the same due diligence that RMF applies to seasoned funds; and it goes in with enough capital to send new funds on the way to their first $100m.
Last autumn, for example, it seeded Balance Asset Management, set up by an experienced team of hedge fund analysts, investment-bank traders and the ex-CFO of hedge fund giant Citadel.
“These people will be successful,” says Mr Hurschler.“But over six months you might see 30 managers start with more than $50m, so capacity is limited, and you have to be global.”
HFIM avoids seeding new managers, as it likes to see operations established and assets ready-allocated.
“There are more prime brokers and business managers helping start-ups,” says Mr Patel. “And we are increasingly seeing platform providers which will enable you to plug your product into ready-made operational, marketing, risk management and compliance infrastructure.”
Early mover
Fortune Group looks to be an early mover, says Mr Hopkins, but acknowledges that start-ups will remain a small percentage of client capital allocation. The firm scrutinises prospects with a private investigative report into personal and professional histories; and will only consider funds with a designated COO or CFO and at least two traders.
However, its preference for managed-accounts means that it can get access to trading skills without much exposure to counterparty risk. “That enables you to cast your net a lot wider in the hedge fund world.”
With some operational risk smoothed-out, is the investment risk suitable for institutions?
“Underperformance is a lot easier to explain when it comes from a seasoned set-up,” says Mr Hurschler. “Pension trustees won’t put their heads on the block for new funds – and that makes sense. Emerging managers present a different risk profile.”
The conventional wisdom is that volatility reduces as funds age, but Ms Jones finds that, although small funds exhibit more volatility and more extreme maximum drawdowns in five-year Monte Carlo simulations, “the young fund index maintained the highest returns, without a corresponding impact on simulated future drawdowns.”
If anything, middle-aged funds suffer a “sophomore slump.” The maximum simulated drawdown of the young funds is -13.04 per cent, against -14.84 per cent for old funds and -17.46 per cent for middle-aged funds.
“That was a surprise to us,” Ms Jones concedes, and she believes that the support structures new managers enjoy, as well as the greater likelihood that they will have previous hedge fund experience, to some extent accounts for this.
Nonetheless, she concludes that investors looking primarily for capital preservation should stick with older funds – and always consider the qualitative aspects of any hedge fund allocation.
“It should be a satellite to enhance your core performance,” agrees Mr Hurschler. “And selecting at random won’t enhance your performance: some people in this business have positive bias. I strongly agree that emerging managers can outperform - you invest at a discount and you can profit from a growing business - but as with every other industry, quality decides.”
HFIM LOOKING TO EVOLUTION RATHER THAN CREATION
HFIM Evolution Funds is an Ireland-domiciled umbrella fund, dedicated to investing in emerging managers, launched in January 2007 by Hedge Fund Investment Management Ltd.
Backed by Dr Nick Dhandsa’s family office and co-founded by Tushar Patel and Raminder Panesar, previously investment manager and COO respectively at GAIM Advisors, the fund of hedge funds arm of Integrated Asset Management, HFIM Evolutions Funds has ten sub-funds. One offers a diversified multi-strategy approach; six are strategy-specific and three offer specific geographic exposure. Each fund of funds can invest in 15-25 newly-established and emerging funds. HFIM envisages that the HFIM Evolutions Funds can manage as much as $1.3bn (€966m).
“As hedge fund investors get more sophisticated, they are increasingly looking for more niche offerings that are differentiated from the existing investments they hold, and for more defined investment exposures,” says Mr Patel. HFIM Evolution Funds offers global macro, long-short equity, commodity and managed futures, emerging markets, market neutral and event-driven funds, as well as Asia-, Europe- and Latin America-focused funds.
HFIM continues to develop a filtering tool to capture global emerging hedge funds and start-ups (whether from a new company or within an established firm). Over the last 12 months, HFIM’s initial tracking captured around 450 funds that met the basic requirements – assets under management below $500m, less than three-and-a-half years’ track record – which were filtered to 250 for closer on-going monitoring by HFIM analysts. A core of around 40 products is under consideration for investment and subject to investment reviews. It is envisaged that the universe of funds tracked by HFIM will rise to over 1000 funds as new funds are launched.
The preference is for funds with committed capital – HFIM does not seed funds, but does not mind being a day one investor. More than 60 per cent of the current Multi-Strategy Fund portfolio has been seeded or anchored by an established group in the industry. Similarly, the firm likes to see managers working within an established infrastructure, such as a hedge fund platform or existing investment firm, to reduce operational and business risk.
The chosen funds are subjected to ongoing monitoring, particularly focused on picking up mean-reversion in performance.
“At this point we would consider putting them on watch and try to understand why there are mean-reverting trends,” says Mr Patel. “Has there been significant asset growth? Has the investment approach changed? Has there been loss of any key person? Has the investment edge been worn away or the strategy become overly competitive or simply no longer works? Then we decide whether or not to disinvest and replace it with another fund.”
Regardless of performance, HFIM has strict limits of 60 months’ track record and $500m of assets under management for all of its underlying funds.
“But there is constant evolution,” observes Mr Patel. “There were 423 European start-ups last year, raising $37bn, almost twice the number from 2005. New strategies, new instruments and new markets continuously evolve.”
Mr Patel says capacity in the HFIM Multi-Strategy Fund is around $400m, with a range of $100m- $250m for the individual strategy funds and geography-specific funds. The minimum investment for HFIM Evolution Funds is €125,000 or equivalent, with dollar, euro, sterling, yen and Swiss franc shares available. There is a management fee of 2 per cent and a performance fee of 10 per cent.
