The Alpha Premium of Emerging Managers

According to the English proverb: ‘hunger is the best sauce.’  

In investment terms, those with the most to gain from strong performance, will work hardest to achieve it. Hunger can, therefore, be one of the best sources of return. When it comes to harvesting the emerging managers’ alpha premium, getting a head start enhances the scale of premium on offer.

The emerging managers’ alpha premium is perhaps best demonstrated in the hedge fund world. Research^[i] has shown that fund managers tend to provide their best performance during their early years. In large part, this is because fund managers trying to establish a new fund are more focused on capturing performance.

Being very hungry is the equivalent of being very focused; not just on posting strong returns to attract investors, but also on managing risk. The impact of a drop in performance will be felt more profoundly by an emerging fund manager trying to attract capital than by a firm with an established investor base. Smaller funds are often also nimbler, allowing them to move assets more quickly and dynamically.  Furthermore, smaller funds can more easily exploit opportunities before they become crowded and the return potential is diminished. This alpha premium is particularly strong where an emerging hedge fund is led by a highly experienced and seasoned portfolio manager who previously worked out of a larger hedge fund or banking firm.

These portfolio managers, who may previously have managed billions of dollars, combine the experience of tenure with the nimbleness of managing considerably fewer assets under management.

Getting a head start

When it comes to harvesting the emerging managers’ alpha premium, the early bird catches the worm.

Just as nimbleness is important for single manager funds, it offers certain funds of hedge funds a head start in building relationships, securing capacity, access to Founder Share Classes and better fees. Smaller funds of hedge funds are therefore far better placed to exploit the alpha premium.

Making investments into emerging fund managers requires experience, particularly considering there is a fine balance between the high failure rate of new funds and the lucrative potential for significant rewards. Any fund of hedge funds should be conducting in-depth research and spending significant resources, particularly time, on understanding their investments in emerging fund managers and how they fit into an overall portfolio. That due diligence and experience often means that funds of hedge funds are well placed to make meaningful allocations that move the needle for both the fund of hedge funds portfolio and the emerging fund manager.

It is easier for smaller funds of hedge funds given the greater efficiency of conducting such detailed fund manager research. Emerging fund managers often need to ramp up to their investment capacity and cannot handle too much capital too early on. A large $5bn fund of funds looking to allocate a 5% position (i.e. $250mn) to an emerging fund manager may not be able to do so given capacity constraints and the size of the emerging fund manager. A smaller allocation that the hedge fund may be able to accept such as $10mn is rarely worth the larger funds of funds investing the time and effort involved to conduct the necessary due diligence and fund manager research.

As larger funds of hedge funds tend to make sizeable allocations, many are effectively ruled out of investing with emerging fund managers until they have reached a ‘critical mass’ whereby the fund of funds would not represent more than 10% of the total AUM in the hedge fund.

The ‘critical mass’ for hedge funds has continued to increase, not only as overall industry assets have increased, but also because of the growing regulatory burden and demand for institutional-level infrastructure. Larger funds of funds tend to wait until a fund manager can demonstrate at least six months’ track record within the existing firm.

Smaller funds of hedge funds, which do not suffer the same structural constraints, therefore have an edge in harvesting fund managers’ potentially strong early years.

The more capacity constrained a strategy is, the bigger the advantage of a head start. In some cases, the performance potential of a fund manager may be significantly depleted by the time they hit the radar of larger funds of hedge funds. Some quantitative/systematic strategies, for example, have high Sharpe Ratios of around three or above, but are more significantly capacity constrained.

Long-term benefits

The advantages of getting a head start continue to benefit investors over the long-term.

Aside from strong performance, the alpha premium has another important element: emerging fund managers are more willing to negotiate on fees.

Investing with fund managers from day one often opens the door to Founder Share Classes, where fund managers offer a certain amount of capacity at lower fee levels which is maintained for the life of the initial investment.

The fee-break that emerging fund managers offer can be substantial and very worthwhile to the investor over time, enhancing the alpha premium available and extending its value. To illustrate this, let us assume a hedge fund returned 15% net of a 2% management fee and 20% performance fee: If fees are negotiated to 1% and 10%, the net return to the investor increases to 17.78%. The effect of compounding over five years would equate to stronger performance to the tune of 25.51% and over ten years the effect of compounding would equate to stronger performance by an impressive 109.15%.

There is another, less tangible benefit available to early-bird investors. In many cases, future capacity can be secured as part of the initial negotiations, allowing the fund of funds first refusal on additional investment opportunities as the fund grows. Even where that capacity cannot be contractually secured, fund managers have a natural tendency to prefer investors with whom they have a strong relationship, especially those who showed support early on. Existing investors often have the ability to opportunistically add to their investments, even in closed funds as there is virtually always a limited amount of rebalancing by investors, or where funds may need to take in a limited amount of capital to cover costs.

As such, the advantage of a head start includes effectively securing capacity for the long-term as some emerging fund managers develop into the ‘blue-chip’ funds of tomorrow.

Harvesting the Alpha Premium of Emerging Managers

Selecting those fund managers is not a straightforward task, however.

While nimbleness is critical to the success of both emerging hedge funds and the funds of funds investing in them, tenure is vital in recognising emerging fund managers with the potential to become the blue-chip firms of tomorrow. At the fund of funds level, experience is critical in being able to identify which funds have the odds stacked in their favour and are, therefore, more likely to succeed.

Harvesting the alpha premium requires an efficient, entrepreneurial, decision-making process to remain nimble. Succeeding over the long-term, however, requires a wide network of relationships and a tried-and-tested ability to select genuine and sustainable talent in a world of increasing dispersion.

For those wanting to exploit the head start advantage, experience, strong industry relationships and a well-established, but nimble investment process are vital attributes. This can only be gathered through tenure and the knowledge born of investing in emerging hedge funds through several market cycles.

Combining a nimble, yet experienced, fund manager selection process with risk-conscious, performance-hungry emerging managers, can yield significant results in terms of performance and downside protection.

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Najy Nasser is a Director at Headstart Advisers Ltd

Henry Watkinson is a Director at Headstart Advisers Ltd

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group

[i] Hedge Fund Research 2012, Pertrac 2012