Emerging hedge fund managers gaining attention despite data
By Christine Williamson | November 28, 2011
Emerging hedge fund managers are getting more attention from institutional investors because they tend to produce better returns than larger, more established funds, but industry insiders disagree about the extent of the outperformance.
Hedge fund investment consultants and early-stage hedge fund-of-funds managers are critical of industry-produced and academic analyses that don't correct for survivorship and backfill biases found in the various public databases that aggregate self-reported hedge fund returns. They say statistical studies that include these two biases produce artificially high returns for both small/young and large funds.
One of the industry's most widely read performance comparison studies, by PerTrac Financial Solutions LLC, showed small hedge funds managing less than $100 million each produced 360 basis points of annualized outperformance over large funds each managing more than $500 million over the 15-year period ended Dec. 31.
Young hedge funds in business less than two years returned an annualized 526 basis points more than those in operation for more than four years over the same time period, PerTrac researchers found.
But PerTrac's most recent analysis of 7,157 hedge funds created from the merger of five hedge fund databases did not correct for survivorship and backfill biases, and the returns calculated by the study are overstated, consultants said.
Survivorship bias is introduced into a hedge fund database when a fund closes and its track record is removed, resulting in improved returns overall because the database tracks only successful funds. Backfill bias occurs when a hedge fund includes past performance in its first report to a database.
The combination of survivorship and backfill biases accounted for 718 basis points of the 14.88% annualized performance of 6,169 hedge funds from within the TASS database for the 15 years ended December 2009 that were analyzed by Roger G. Ibbotson, Peng Chen and Kevin X. Zhu.
Lisa Corvese, managing director of global business strategy of New York-based PerTrac, a financial software developer, said instant-history and survivorship biases are “inherent in all publicly available hedge fund databases” because there is no standardization of the data requested of hedge fund managers by database vendors.
“People rant about these biases all the time, but no one has a good, easy solution for getting rid of them,” Ms. Corvese said.
The good news for institutional investors is the small cadre of institutional-quality emerging hedge funds run by experienced portfolio managers has outperformed larger funds over time, just by a smaller percentage than industrywide statistics suggest.
Small firms, bigger returns
Based on their own investment experience and analysis of multiple databases, hedge fund seeders and investment consultants agreed that this select group of small hedge funds with track records of three years or less outperformed larger funds by an estimated annualized rate of one to two percentage points over the 10 years ended Sept. 30, through a combination of alpha generation and discounted fees.
Outperformance would be higher if revenue shares that kick a portion of the new hedge fund's profits back to investors and seeding equity stake profits are added to the aggregate mix.
Investors increasingly are ignoring the fracas over data analysis and the lack of public information and are investing with hedge fund-of-funds managers that don't need to rely on hedge fund databases to find great young managers.
The hedge fund-of-funds managers include Protege Partners LLC, Blackstone Alternative Asset Management, Larch Lane Advisors LLC, Rock Creek Group LP, IMQ Investment Management BV and Pacific Alternative Asset Management Co. LLC.
Institutional investors seeking the promising returns of new and small hedge funds include the $133.8 billion New York State Common Retirement Fund, Albany; the $490 million Richmond (Va.) City Retirement System; and New Jersey Division of Investments, Trenton, which had investment responsibility for $66.4 billion as of Sept. 30.
The $37.4 billion Illinois Teachers' Retirement System, Springfield, already has invested $42 million in two early-stage hedge fund managers through its $500 million emerging managers program and likely will add another new fund next year. The plan also seeks to add more exposure to small or newer hedge funds in 2012, possibly through investment in a seeding fund (Pensions & Investments, Oct. 31).
The $227.5 billion California Public Employees' Retirement System, Sacramento, uses a pool of eight hedge fund-of-funds managers to run an emerging hedge manager portfolio that totaled $1.5 billion as of Sept. 30.
“These emerging manager funds of funds are a value proposition for us. They give us the potential to build a relationship with a small manager within a fund of funds and to occasionally graduate a manager into the direct investment portfolio,” Craig Dandurand, portfolio manager for CalPERS' hedge fund portfolio, said in an interview.
CalPERS has graduated three young hedge funds from the emerging hedge fund-of-funds program and into its $3.8 billion direct investment portfolio.
In September, the system invested $100 million directly in emerging global macro fund manager Breton Hill Capital Ltd. which carried with it revenue shares that give CalPERS some of the new firm's profits, a move that Mr. Dandurand stressed was not a sign that the pension fund is setting up a seeding program.
Mr. Dandurand said most of the established managers in CalPERS' direct investment program are small to medium-sized by design.
“I would rather hire a $200 million shop than an $8 billion manager. Small managers are just hungrier and less motivated by asset gathering than they are by performing very well,” he said.
Large funds like CalPERS, as well as early-stage, specialist hedge fund-of-funds managers, are being barraged by a rash of new hedge fund companies seeking institutional cash. But very few new funds make the first cut.
“The bar is high,” said Mark Jurish, Rye Brook, N.Y.-based Larch Lane's CEO. “Our team meets with dozens of early-stage hedge fund managers seeking capital, the majority of (which) do not have the appropriate infrastructure in place to make it through even the first stage of our process.”
Larch Lane managed $1.4 billion as of Oct. 31.
Seed investor IMQ Investment Management's business model relies on catching new companies launched by very experienced investment teams even earlier: The firm is involved right from the start as the first investor in the new hedge fund.
The IMQubator investment team brings a e25 million ($34 million) seed investment, but also insists on taking a 25% equity stake in the new firm, requires a three-year lockup on the investment, and requires that the hedge fund portfolio managers work in the firm's Amsterdam office for at least three years, said Jeroen M. Tielman, CEO and founder.
In 2009, a year after IMQubator's launch, Dutch institutional investment manager APG Algemene Pensioen Groep NV, Heerlen, invested e250 million in the firm's seeding program.
By the end of this year, Mr. Tielman said the fund will have invested in 10 young European and Asian hedge fund managers.
“The seeding moment is a unique one,” Mr. Tielman said, because “as the sole seed investor, you can push for the best governance, the best alignment of terms, and the complete transparency. And because there is such a high reputational dimension for new hedge fund managers, they will give everything to their investment process to make sure it's a success. It's like competing in the Olympics. They only get one chance to prove their worth.”
A smaller asset base can be an advantage for hedge fund managers, especially for strategies that are capacity constrained, said Jeffrey Tarrant, founder and CEO of Protege Partners, New York, which specializes in seeding and investing in smaller hedge funds.
Institutional investors are starting to look for managers that will diversify their hedge fund portfolios as they realize that there is “a lot of overlap between in the equity portfolios of their large hedge fund managers. Large hedge funds by necessity have had to start fishing in large-cap ponds, even if they used to be small enough to fish in small- and midcap pools,” Mr. Tarrant said.
“Smaller hedge fund managers are far more able to move more nimbly in and out of small-cap stocks, but can invest in large-cap stocks if they want to,” Mr. Tarrant said. He added that small managers tend to stay true to their investment style because they aren't forced by their size to deviate in order to put money to work.
Protege Partners managed about $3 billion as of Oct. 31.