Emerging Managers Shine at Hedge Fund Summit

Date: Thursday, February 24, 2011
Author: Alex Akesson, HedgeCo.net

New York (HedgeCo.net) – Opal Financial Group sponsored the recent Emerging Managers Summit, and over 300 institutional investor participants heard loud and clear what has become well-established: Emerging investment fund managers consistently outperform large and brand-name investment firms, and they do so with less volatility of returns.

The Emerging Manager Summit meetings were attended by institutional investors that included trustees of endowments, retirement funds and family offices. Many of the attendees were trustees of police, retirement, insurance, education and other funds. Speakers included representatives of the Texas Permanent School Fund, Baltimore Retirement System, New York State Insurance Fund, Austin Police Retirement Fund and the NYC Board of Education Retirement Fund. These institutional investors discussed in depth how to find, analyze and invest in emerging investment funds in order to enhance portfolio investment returns.

Empirical Studies on Emerging Managers.
The institutional investors discussed the highly-regarded empirical studies, which confirm that emerging managers as a group have outperformed larger investment funds. Northern Trust, which manages almost $660 billion, has invested approximately $5 billion with more than 40 emerging investment management firms and has spent a significant amount of time studying them.

Their November 2010 study, entitled “Tenth Anniversary Study Reconfirms Emerging Managers Have Edge over Larger Investment Firms,” concludes that the smallest investment firms outperformed the largest firms and all other groups studied, as well as the S&P 500 Index, over the five-year period ending June 30, 2010. Northern Trust compared large and small investment firms in up and down markets and found that small firms have an advantage over large firms, stating that “small firms delivered dramatically better performance in down markets.” Furthermore, “in up-market periods, small firms outperformed just as often as other firms, but by a smaller margin.

In down-market periods, however, small manager composite outperformed in every case, and by the widest margin by far of any group.” In Northern Trust’s opinion, smaller managers outperform larger managers because of a less bureaucratic working environment, greater motivation and greater flexibility to deal with changing market environments.

HFR Asset Management was cited for their recent study entitled “Emerging Manager Out-Performance: Alpha Opportunities from the Industry’s Newest Hedge Fund Managers.” HFR says “emerging managers are generally smaller and well suited to adapt to changing market conditions and exploit new opportunities…new ideas are more likely to generate superior returns than are copycat ideas.” They attribute emerging managers’ superior returns to an increased likelihood that they have new ideas and the nimbler nature of smaller funds, which gives them the ability to focus on their best investment ideas and to apply specific expertise to niche exposures.

Harcourt Investment Consulting AG, with $4.7 billion in assets under management, completed a Strategy Focus Report entitled “Investing in Early Stage Hedge Funds.” The report states “at Harcourt, we frequently and enthusiastically allocate capital to these younger, smaller hedge funds; and our experience has shown that young funds consistently outperform older funds. Accordingly, a host of research supports this notion.” Harcourt cites additional studies by LJH Global Investments, Putnam Lovell and Morgan Stanley Quantitative Strategies. Harcourt quotes Warren Buffett of Berkshire Hathaway, who has stated that large funds are pressured to “chase the elephants” while young funds can invest more nimbly and proactively by focusing their portfolio on their very best ideas.

Why Emerging Managers Outperform Larger Funds.
The institutional investors unanimously agreed that emerging managers usually have unique or niche strategies as a result of a star manager’s expertise, while larger funds, because of their big size, typically drift to a multi-strategy style and often have half a dozen or more, younger and less experienced portfolio managers. One fund manager noted that an investor’s interests are more closely aligned with the emerging manager’s interests than with the larger fund manager’s interests because the emerging manager’s own capital is usually a large percentage of their fund’s capital. So, while a star emerging manager has the capability, motivation and incentive to generate superior returns with less risk, a larger multi-billion dollar fund manager is often motivated to increase the fund’s size, generate average returns and earn substantial management fees.

How to Pick an Emerging Manager.
The institutional investors agreed that the “starting place” for picking an emerging investment manager is, first, to look for one that consistently generates superior investment returns. Second, they must generate higher returns without higher risk and volatility. They highlighted that world market conditions and economic volatility will likely continue to cause risk to investment returns and that, therefore, they will consider only funds that performed reasonably well in 2008. Additional key emerging manager attributes included managers that had a track record of at least 5 years and an investment management team with strong educational credentials and work experience.

The sponsors of the Emerging Manager Summit performed their own search for an investment fund manager who met all of the criteria required by institutional investors and found one, who was asked to present his investment strategy. Alan Donenfeld of Paragon Capital LP really impressed the audience.  Donenfeld runs a private, event-driven fund that has generated spectacular investment results. Paragon has delivered an audited investment return of more than 300% since inception 6 years ago in 2005, which equates to a 35% average annual investment return after all fees and expenses.

Donenfeld explained that, with 30 years of investing experience behind him and after working for years at Lehman and Bear Stearns, he cashed out and set up a private fund to invest his own capital. Given his extraordinary returns, friends and family asked to invest alongside him. He described how he develops and uses proprietary information and knowledge to uncover undervalued and mispriced securities. He opportunistically takes advantage of a catalyst event and is able to generate excellent returns with reduced risk. To support his investment style, Donenfeld has added a team of investment experts and uses top legal, accounting and administration service firms.

Alan Donenfeld was asked by an audience member how he generated such a high average return of 35% per year since 2005. Donenfeld responded that, since he and his family have a large stake in the fund, he makes every investment decision in a methodical manner to maintain significant upside return on his investments, with an eye on preventing loss and volatility. He pointed out that his niche event-driven investments are typically deep-value investments in mispriced or undervalued securities with low downside, but with tremendous upside potential. Furthermore, he stated that when most other managers pick an investment, they hope it will go up.

The conference concluded with investors discussing their current allocations to emerging managers and their satisfaction with emerging manager performance. They shared information about their specific emerging manager investments and continuing the search for the next hot manager.