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Industry voices

A rising class of emerging managers: Women- and minority-owned hedge funds

Seedling

Over the past few years, the demand from institutional investors for women- and minority-owned hedge funds (typically known as women and minority business enterprises) has grown significantly. Various states have enacted legislation either mandating that a minimum percentage of public pension assets be allocated to such enterprises (Illinois) or at least encouraging that the firms be considered in the allocation process (New York, Maryland). Even where states might not have legislatively mandated women and minority business enterprise investment by their pension plans, many state or local government pension plans — including those in California, Florida, Minnesota, New Jersey, Ohio, Oregon, Pennsylvania and Texas — are actively investing in, or seeking to invest in, WMBE-managed hedge funds.

While many pension plans initially satisfied these requirements by allocating long-only stock and bond portfolios to WMBE, many are now implementing WMBE investing as part of a larger emerging manager program for a portion of their hedge fund allocation. Although many WMBE funds are well established, a majority of them are smaller, younger and fit into the emerging manager category as well.

The rationale for implementing WMBE programs varies, but some of the typical drivers include ensuring the composition of firms managing pension assets mirrors the employee/customer base and providing opportunities to managers that have historically been underrepresented in the investment management arena in order to cultivate a more diverse talent pool.

Like early-stage hedge funds in general, WMBE funds might have the potential to outperform established hedge funds because of their ability to stay nimble, access less crowded trades, focus on performance, and provide enhanced transparency and potentially reduced fees.

However, as pension funds generally have a fiduciary duty to act in the best interest of plan participants by managing risk and generating the best returns possible, meeting performance objectives must remain a primary concern. As a result, many pension funds look to allocate to WMBE hedge funds as part of a broader “emerging manager” program where the objective is to invest with smaller/less established managers.

A number of research studies have shown that smaller and younger hedge funds have historically outperformed more established managers. Most WMBE hedge funds are managed by smaller, less-established firms; according to a June 2011 study by Barclays Capital titled "Hedge Fund Pulse, Affirmative Investing: Women and Minority Owned Hedge Funds," the median assets under management of WMBE hedge funds is only $65 million. As such, WMBE hedge funds might also have the potential to outperform more established managers.

While WMBE hedge funds’ potential to perform in line with their smaller and younger hedge fund counterparts might present an opportunity, investing in smaller and younger managers can also present a unique set of challenges. By definition, emerging managers do not have lengthy track records, making it more difficult to evaluate the talent and capabilities of the investment team. There are a number of issues and solutions that investors should consider when evaluating any emerging manager, including WMBE hedge funds:

IssueSolution
Limited Track RecordFocus on funds managed by professionals with a prior demonstrated record of success
SourcingWork with allocators who are consistently working with WMBE funds
Standards of operational due diligenceWork with allocators that have specialized professionals dedicated to evaluate a fund's operations and who apply rigorous standards regardless of a fund's size or age
Business sustainability riskFocus on strategies that do not require significant infrastructure and funds that have a well articulated business strategy and sound investment process

A well-executed WMBE hedge fund program should allow an institutional investor to satisfy both its legislative mandates and its fiduciary obligations by adding high-quality WMBE investment managers to the portfolio.

David Katz is the president and chief operating officer of Larch Lane Advisors LLC, Rye Brook, N.Y.