Emerging managers seeing renaissance among investors

Some of the world's largest pension funds are increasingly turning to emerging managers to generate alpha, particularly in alternative asset classes where more nimble players might have an edge.

“There is renewed interest in emerging managers, stemming in general from investors looking for diversity among managers — not necessarily just on an outperformance level but also (in terms of) diversity in investment ideas, which may be coming from smaller firms,” said Andrew Junkin, managing director at investment consultant Wilshire Associates Inc. based in Denver.

Furthermore, major organizational changes at larger firms have led some investors to opt for smaller managers “with the view that they may be more nimble in certain areas of the market,” Mr. Junkin said. “Smaller managers can provide organizational stability, and more of them tend to fall into the (women and minority business enterprises) category.”

In the U.S., regulatory and social pressure over the years has led many public pension funds to implement emerging manager programs dedicated to attracting more women and minority business enterprises. But even among institutions that don't have the same requirements, commitments to emerging managers are rising, sources said. More recently, these programs have been broadened in terms of asset classes to include more alternatives including hedge funds, private equity and real estate.

“Alternative strategies are well-suited to the emerging manager construct, as the alpha component of returns is more meaningful” compared to traditional asset classes, said Mark Yusko, chief investment officer of Morgan Creek Capital Management, which is running emerging managers strategies for the $21.2 billion Employees Retirement System of Texas and the $108.9 billion Teacher Retirement System of Texas, both of Austin.

The difference between the top and bottom performers in fixed income, for example, is maybe 100 basis points. Among alternatives managers in asset classes such as private equity and real estate, the difference could be “as high as thousands of basis points,” Mr. Yusko said. “The bigger (performance gap) between the best and the worst managers means more opportunities for managers to differentiate themselves through alpha generation.”

In addition to the two Texas giants, other pension funds expanding or considering adding to their emerging managers programs include the e274 billion ($355 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands; $245.3 billion California Public Employees' Retirement System, Sacramento; the New York City Retirement Systems, with about $122 billion for five city pension funds; and the £36 billion ($58 billion) BT Pension Scheme, London.

“What we've found is that by engaging with smaller managers, we were able to help them build a (business) structure that's more operationally robust and transparent,” said Mark Barker, co-CIO and founding partner of Hermes BPK Partners, which has $2.4 billion in hedge fund-of-funds assets under management. Hermes Fund Managers Ltd., which is owned by the BT pension fund, holds a majority stake in Hermes BPK.

Earlier this year, Hermes entered into a 50/50 joint venture with Northern Lights Capital Group LLC to launch a dedicated fund focusing on providing acceleration capital to emerging managers running absolute-return strategies.

CalPERS, which invests about $10 billion spread among 300 emerging managers, in August launched a five-year plan “to better understand the business case for emerging manager strategies and deploy capital in the future based on the lessons learned from past experience,” according to plan documents. “The ultimate measure of success for our (emerging managers) programs is investment performance against benchmark, and to date, performance against this metric has been mixed.”

As part of the five-year emerging manager plan, CalPERS will add new asset classes, including a $200 million commitment to a real estate strategy. A strategic review will be completed for certain areas within the program, in addition to creating “benchmarking analysis by asset class,” according to CalPERS. For the first time in the program's history, formal criteria will be established “to evaluate emerging managers' potential for direct investment mandates.”

“As (clients) expand their views of the role that emerging managers play within their portfolios, they're becoming more thoughtful in the implementation” of emerging managers programs, Mr. Junkin said. For example, “instead of carving out 10% of the domestic equity portfolio and investing it with emerging managers, they're finding talent across the emerging managers space. It's much more broad-based.”

Among hedge funds, for example, firms with less than $100 million in AUM returned 12.5% on an annualized basis since 1996, compared with 9.16% for firms with more than $500 million during the same period, according to “Impact of Size and Age on Hedge Fund Performance: 1996-2011,” a report published in October by PerTrac Inc.

However, the average large hedge fund also didn't fall as much as the average small fund during the negative performance years, according to the report. In 2011, for example, the average large fund fell 2.63% compared with a 2.78% decline for the average small fund.

The biggest money managers continue to attract the majority of new inflows, whether in traditional or alternative asset classes, sources said. However, investors are recognizing that “there's more of a possibility to generate premium returns” with emerging managers, said Jeroen Tielman, chief executive and founder of IMQubator, a hedge fund seed investor backed by Dutch fiduciary manager APG Group.

“It makes sense for institutions to invest at least a part of their portfolios in emerging managers,” said Mr. Tielman, whose Amsterdam-based company received e250 million from APG to invest in 10 hedge fund managers and is targeting an additional e100 million from other institutions to close the first fund later this year. IMQubator plans to launch a second fund next year. APG, which manages the Dutch ABP fund, will likely invest in the second fund.

The pool of emerging managers in alternative asset classes is also deepening. Regulatory changes in investment banking, including the Volcker rule, and the demise of proprietary-trading desks are creating incentives for employees to start their own businesses, said David Katz, president and chief operating officer of Larch Lane Advisors LLC, Rye Brook, N.Y. Larch Lane manages about $1.4 billion in emerging manager strategies.

“Banks will continue to shrink hedge fund portfolios, resulting in increased alpha potential especially for smaller managers,” Mr. Katz said. “There will be less assets chasing the same trades.”

While smaller managers' “ability to get off the track when the train is coming” is important to investors, major resources are needed to implement an emerging managers program, Hermes' Mr. Barker said. “It is a lot of effort in order to put a relatively small amount of money to work,” but the upside potential is significant, Mr. Barker added.

However, failure rates through lack of business sustainability are higher among smaller managers. “Long-term capital, coupled with operational engagement, can significantly mitigate this risk and can provide a mechanism for substantial additional compensation to investors,” Mr. Barker said.

The impact of a higher failure rate can be eased somewhat by using a multimanager strategy to spread the risk and also by skillful manager selection. At Wilshire, Mr. Junkin looks for a stable organization, a sustainable investment process and a suitable level of risk management for the investment process.

“We like the idea of accessing investment talent when it's still relatively young, relatively poor and relatively small,” said Mr. Yusko, whose firm has about $7.5 billion in AUM. “We don't want (to hire) managers who are so young that they have no experience, so poor that they haven't been successful in the past, or so small that they're struggling to keep the lights on. But we do want them to be hungry, nimble and focused.” n