Institutional investors opting for emerging managers as established funds stutter

Date: Tuesday, September 6, 2011
Author: Charles Gubert, COO Connect

Institutional investors are increasingly shunning established hedge fund managers following a series of lacklustre performances in favour of their smaller counterparts, according to a leading fund of hedge funds (FoHF).

This comes as several major hedge funds nursed significant losses during the volatile summer period just gone. The $36 billion Paulson & Co saw its flagship Advantage Plus Fund drop 14% in August with year-to-date (YTD) losses of 39%. JP Morgan’s long/short equity fund Highbridge Capital was down 9.2% while Owl Creek Asset Management’s $5 billion flagship fund lost 5% in mid-August.

“A lot of FoHFs and other sophisticated investors are opting for boutique, esoteric hedge fund strategies as opposed to the brand-name, blue-chip businesses. Most sophisticated investors, particularly the US-based endowments and foundations, are starting to prefer the smaller firms,” said Peter Madsen, director of marketing at the $1.2 billion, London-based Cube Capital.

These thoughts were echoed in a 2010 report by research firm Preqin, which revealed 72% of FoHFs would invest in an emerging manager while a further 13% would consider it. Some 66% of endowments acknowledged they would allocate capital to an emerging manager too. A 2011 JP Morgan Capital Introductions Group survey also stated 37% of investors were comfortable with putting money into a hedge fund with less than $50 million in assets in 2010 compared with just 25% in 2009. However, it added managers were expected to have a minimum of two years investment experience.

Hedge funds had their worst monthly performance since the demise of Lehman Brothers almost three years ago with managers on average losing 4.1% in August, according to data from the Chicago-based Hedge Fund Research. The projections for emerging managers appear to be more positive. The Neuberger Berman 2011 strategy outlook report published earlier this year said emerging managers’ annualised returns stood at 9.49% compared with 7.61% for their more established peers.

Nevertheless, some institutional investors such as pension funds, will be reluctant to allocate to emerging managers, added Madsen. “The large pension funds will always invest into the big FoHFs and mega managers as they typically do not have the infrastructure and degrees of freedom that allows them to find and select ‘off-the-run’ managers,” highlighted Madsen, echoing the mantra that nobody was ever fired for investing into IBM.

Large institutional investors often have concentration limits forcing them to focus their efforts on the biggest managers. The JP Morgan survey said that 43% of investors whose average ticket size exceeded $250 million would not consider managers with less than $1 billion in assets.

“Many FoHFs who focus on the large managers find themselves exposed to the same strategies or investments. This is why we go after smaller managers as they outperform their peers and there are more opportunities. Smaller firms are more nimble and hungry,” said Amos Mwaniki, director of operational due diligence at Cube Capital.

Emerging managers’ strong performances is not the only attraction. Many adopt a positive attitude towards transparency – something that cannot always be said of larger managers. “Smaller managers tend to be more flexible and transparent. Often at larger managers, there are investor relations departments and it can be hard to get through to portfolio managers or senior executives. It is not as crowded in smaller outfits,” stressed Mwaniki.

However, emerging managers do need to adhere to high operational standards if they are to secure investments. “We expect to see a high quality operational infrastructure including a strong board, compliance with regulation and independent service providers,” said Mwaniki.