Emerging managers finding more opportunities coming from institutions

Institutional investors are increasing their interest in emerging money managers as they seek diversity and new talent for their roster.

“A lot of (pension funds) are looking at emerging managers right now, particularly in small-cap and smidcap,” said Keith Robinson, a managing partner with Focus Consulting Group Inc., Chicago, a consultant to money managers.

“The whole idea of diversifying portfolios and looking for new talent opportunities has certainly become much more the practice among institutional investors, rather than the exception,” said Thurman V. White Jr., president and CEO at Progress Investment Management Co., a San Francisco-based minority- and women-owned manager of emerging managers.

Almost every asset owner or governmental entity has a different definition of an emerging manager. Illinois state law, for example, defines an emerging manager as a firm that is minority- or women-owned or is owned by a person with a disability, and has between $10 million and $10 billion in assets under management.

Others say the firm should have less than $2 billion in AUM and often, include the requirement that the firm be owned by minorities, women, veterans or the disabled.

Opportunities among institutional investors for emerging managers appear to be growing.

“You're continuing to see an expansion of potential RFPs to emerging managers,” Scott Dooley, founder and chief investment officer of emerging manager Fusion Investment Group LLC, Pittsburgh, said in a telephone interview. “You originally saw these mandates from the state level. Now, you're starting to see these RFPs trickle down to some of the smaller pension plans. Five years ago when we started, that wasn't the case.”

Fusion has nearly $200 million in assets under management, specializing in global tactical asset allocation.

Several institutional investors told Pensions & Investments that investing in emerging managers has often led to strong returns and positive results.

Jay C. Rehak, board president of the Public School Teachers' Pension & Retirement Fund of Chicago, said hiring minority-, women- or disabled-owned managers is“just good business” and has “worked out great” for the Chicago fund. “We've had great returns over the years.”

Mr. Rehak said he didn't have data on how the pension fund's emerging managers performed relative to all managers. But he did have information on individual firms.

Garcia Hamilton & Associates LP, Houston, runs $103 million in core fixed income and according to Mr. Rehak, that portfolio has outperformed its benchmark, the Barclays Aggregate Bond index, by an annualized 172 basis points from inception on October 2010 through Dec. 31, 2014.

For the three years ended Dec. 31, Garcia, on an annualized basis, outperformed the benchmark by 303 basis points. For the year, it outperformed by 202 points. The firm bested the index by 72 basis points and ranked second in its peer group in the fourth quarter of 2014.

LM Capital Group LLC, San Diego, has managed core-plus bonds for Chicago Teachers since November 2004. The portfolio now stands at $205 million. LM's portfolio returned an annualized 2.92% for the three years ended Dec. 31, vs. 2.66% for its benchmark, the Barclays Aggregate. For five years, LM returned an annualized 4.49% vs. the benchmark's 4.45%. Since inception, LM's portfolio returned 4.69%; the index, 4.64%.

Roughly one-third of the pension fund's $9.7 billion is invested with minority-, women- or disabled-owned managers.

“The New York City pension funds are always on the lookout for firms that practice diversity and can win in the marketplace,” New York City Comptroller Scott M. Stringer, fiduciary for the five public pension funds that make up the $163.4 billion New York City Retirement Systems,said in an e-mail. “Last year we made a new $1 billion commitment to our emerging managers program.”

Minority- or women-owned money managers run about $11 billion — or 6% to 7% of assets — for the New York City system.

Solange F. Brooks, portfolio manager in the investments executive unit at the $188.8 billion California State Teachers' Retirement System, West Sacramento, said that typically, “the smaller managers are hungrier and willing to go that extra mile. They'll do their very best.” Ms. Brooks declined to cite a specific manager.

One advantage of being a small manager is nimbleness.

“We can be much more nimble in markets that are challenging. We don't have to buy tens of millions of dollars' worth of a security,” said Barbara J. McKenna, managing principal at Longfellow Investment Management Co., Boston, a woman-owned fixed-income and alternative strategies investment manager with about $6.5 billion in AUM.

Janie Kass, the San Francisco-based managing director for money management consulting firm Margolis/Kass Advisors Inc., said emerging managers are “generally known to be more agile and nimble. In some asset classes in, say, small-cap, they can go in and invest the money without having a major impact.”

Having more direct contact with the senior executives at the firm is another advantage for asset owners. John Chalker, co-founder and managing director of LM Capital Group, said at his firm, the client “can have direct contact with the portfolio manager that has his or her hands on the money.” LM Capital currently manages $5.2 billion.

Longfellow's Ms. McKenna agreed. “We have much more direct contact with our clients, and there aren't layers. Our clients like the idea of picking up the phone and talking to someone who knows about their portfolio.”

Others say firms with a diverse leadership typically avoid groupthink, which can result in outperforming their larger, more established peers.

“A major reason why investors are looking at emerging managers is smaller managers tend to outperform larger managers,” said Eric Bundonis, portfolio manager, director of research and investments at Altegris Advisors, a La Jolla, Calif., liquid alternatives manager with $2.5 billion under management.

For example, the $132 billion Teacher Retirement System of Texas' emerging managers portfolio, which seeks to mimic the allocation of the total portfolio, returned 14.5% in the year ended Sept. 30, compared to 11.6% for the whole fund, said Cheryl Lynette Hines, director of the Austin-based pension fund's emerging managers program, at the pension fund's Feb. 12 meeting.

Data from eVestment LLC, Marietta, Ga., show that on a risk-adjusted return basis, U.S. equity managers with less than $3 billion largely trailed their counterparts with assets greater than $3 billion. Median Sharpe ratios for smaller managers over three-, five-, and 10-year periods ended Dec. 31 trailed by 15, seven and two basis points, respectively. The Sharpe ratio measures risk-adjusted returns.

Managers identified as minority-owned (greater than 50% of firm ownership), also lagged managers with more than $3 billion in assets — but by a slimmer margin. Median three-, five- and 10-year Sharpe ratios of minority-owned firms were, respectively, three, four and one basis point behind.

Results were more positive for emerging and minority-owned managers when looking at U.S. fixed-income strategies. Median Sharpe ratios for emerging managers trailed large managers by four basis points over three and five years, but were two basis points higher over 10 years.

Minority-owned firms' three-year median Sharpe ratios trailed those of larger managers by four basis points. Their Sharpe ratios were five points higher over five years, and 11 points higher over 10 years.

“Being ready for prime time seems to be the biggest challenge, since that takes time and money,” said Focus Consulting's Mr. Robinson. “Regulatory changes have added a lot of compliance responsibilities, so that's added a lot more costs.”

Fusion Investment's Mr. Dooley and Longfellow's Ms. McKenna noted their size often puts them out of the running for institutional mandates. A small staff — a boon to clients who want easy access to their portfolio managers — can also be a problem, especially if a client wants the level of reporting and servicing that a large firm provides.

“The ability for us to replicate some things quickly and easily isn't the same as a large firm with an entire department dedicated to that type of reporting,” Ms. McKenna said.

The biggest challenge for smaller managers, LM Capital's Mr. Chalker said, “is convincing potential clients that the firm is going to be here three, five and 10 years from now.”

Tina Byles Williams is founder, CEO and CIO of FIS Group Inc., Philadelphia, a manager of emerging managers specializing in international equities. She noted the move to passive management is also a big challenge that emerging managers face. “There are no passive emerging managers,” Ms. Williams said.

Senior Reporter Christine Williamson contributed to this story.