Guest Post: The 800-pound Hedge Fund Gorilla Might Have a Monkey on its Back

We’ve received permission to reprint the following Interesting piece out today on All About Alpha showing three separate research pieces which point to better performance for smaller managers over the 800 pound gorillas of the hedge fund world.  This mirrors some research we did in 2010 and posted in our newsletter titled: Is bigger better? Looking into Large versus Emerging Manager Performance.

Hedge funds are netting at least $10 billion a month of inflows this year, but it seems most of the moolah is headed for the eleven-figure, ten zeroes in assets club of managers with $10 billion or more. However, those 800-pound hedge fund gorillas might just have some impudent young monkeys hanging on their backs and showing them up in the performance department.

This Pertrac study found smaller funds outperformed by 5% a year in absolute terms over 11 years. Jorion and Aggarwals’ widely quoted study found emerging managers generate an extra 2.71% in their first two years( and younger managers tend to be smaller) . While this Singapore university study from Melvyn Teo identified 2.75% outperformance, on a risk-adjusted basis. Both of these last two studies insist they have controlled adequately for backfill bias.

Figure 1 Annual Outperformance of Smaller Managers – Selected Studies

Source: AAA staff, created from cited papers

Reasons behind the apparent absolute outperformance are explored in this paper, which says smaller managers are “often be more flexible in their investment approach and better at exploiting niche opportunities, especially in new under-developed and under-researched markets, and be quick to implement investment ideas”. Another paper simply argues that “small firms have greater motivation to produce strong performance.” Skeptics may say that survivorship bias is bigger for smaller funds, and that topic attracted a lot of reader attention in this posting.

Yet what all of these studies seem to ignore can sometimes be far more lucrative than the investment performance: getting a piece of the economics. Seeders feel no shame in quoting Jerry Maguire and saying to start ups “show me the money,” through a share of one or more of the management company, revenues, or fee discounts. Some seeders even end up with all three of these kickers turbocharging their returns, not to mention preferential capacity agreements.

Looking at fee discounts alone, the chart below shows how much a typical seeding 1 and 15 fee structure can enhance returns by, relative to traditional 2 and 20, for a manager making 12% gross a year. Over 10 years the lower fees boost returns by over 30 percentage points.

Figure 2: Returns and Fee Structures

Source: AAA staff, simulation

The most experienced hedge fund allocators remain so enthused about emerging managers that they have even set up separate ventures dedicated to hunting this fresh talent: over in open minded Amsterdam ,Europe’s biggest pension fund, ABP of the Netherlands has a joint venture called Imqubator that has seeded 10 managers and is about to get another capital infusion from its parent. Meanwhile in London one of the first funds of hedge funds, FRM, has similarly seeded at least 7 managers so far since 2008. With Barney Frank and Chris Dodd chasing top prop traders out of the revolving doors of the banks, the supply of talent should be greater than ever.

It is possible that other pension funds sometimes starting hedge programs for the first time just feel safer with big names ? If pension funds are behind more and more of the flows, then according to thisrecent AAA posting it’s possible the 800-pound gorillas of the hedge jungle just better at camouflaging their strategies in labels and structures like “portable alpha” and “risk parity” that catch the eye of pension allocators.  Smaller managers need to be adept at packaging their strategies into formats such as overlays that can be strapped onto a pension fund with minimal capital outlays. They should also offer investors a menu of both beta, and customized liability, benchmarks to act as reference points for setting performance fees.

This document setting out the California Public Employees’ Retirement System’s policies for its currency overlay programs could be a starting point. Note that CALPERS has also awarded emerging managers mandates to Paamco, 47 degrees North, and Rock Creek: the world’s biggest is setting an example that others may follow.


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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.