Single strategy hedge funds, particularly smaller ones, are not as risky as many may assume. In fact, up-and-coming offerings can be in that sweet spot of attractive investment: small enough to be flexible and dedicated enough to offer true alignment of interests with investors.
There are many phases in the life of a hedge fund, but broadly speaking they can be segregated into three general stages: incubation/start-ups, those gaining traction but still sub-$750m and the large, more mature end of the market.
At the start-up end there can be plenty of investment risks and many centre on the business itself. In today’s environment, being a good manager is not enough – you also need the appropriate staff and infrastructure in place for the business. As a consequence, some never make it out of the incubation phase – there is a large failure rate among single strategy hedge funds.
At the mature end of the market are funds that have been around for years, and while the business risks are more muted in such offerings, there are downsides present. For one, many of the more mature funds are large in size, having proven their ability and attracted assets. This can make them expensive to access. Larger firms and funds can also become more risk averse, hampering returns, while sheer size alone also means they may have reduced capacity for attractive bets within their respective strategies. Whilst stability is provided at the bigger firms, the more entrepreneurial managers will likely find the autonomy and independence very appealing in a smaller set-up.
It is in the middle ground, the exciting phase two, that family offices should seek out greater opportunity, as it is here where interesting choices can lie. To be considered an ‘emerging’ manager as opposed to one still in the incubation phase, the fund will have to have garnered some assets, typically over $50m.
**Higher returns**
Performance is the first appeal of funds at this stage in their development. Recent studies of long/short equity hedge funds between $50m and $500m in size and those with more assets show distinct outperformance at the smaller end. According to the February 2013 Beachhead Capital study, smaller funds have outperformed larger hedge funds by 254bps and 220bps per annum over five and 10 years respectively. Virtually all of this performance was due to alpha generated by the managers, not beta. Likewise, another industry study into a broader range of hedge fund strategies asserts that emerging/early stage managers try harder, which translates into excess returns or alpha of 200bp–400bp per annum over more established managers. It goes on to note that not only are annual returns higher but drawdowns over one year were on average smaller (-13.73% versus -19.45%). Similarly, the Beachhead study points out that while emerging managers of long/short products may feature slightly higher standard deviation scores, their drawdowns over five to 10 year periods have been broadly in line with their larger counterparts.
The threshold of when size starts to impact potential returns is often debated, but the Beachhead study shows a peak differential in 10-year returns between large and small funds at an asset size of around $500m, narrowing thereafter.
**Greater transparency**
Performance is just one attraction for hedge funds at the early stage in their development; another is increased transparency. Managers of smaller funds are often far more accessible, enabling early investors to establish what can be long-held relationships. Being able to spend more time with the manager enables a better than average understanding of the investment fund, how it is performing, in what it is invested, as well as keeping tabs on how the business itself is developing.
Underperformance is not always a warning sign that something is wrong with a fund; there are many other factors to consider. More subtle and yet equally important in terms of the fund continuing to meet one’s expectations are style drift, position sizes exceeding what one was originally told, senior staff leaving, excessive marketing by the manager in an effort to boost assets or a change in closure targets. These are crucial aspects of which investors need to be kept abreast, and having a personal relationship with a manager, established early on, can make this easier.
Another draw for smaller funds is they can actually be more investor friendly, for instance being slower to raise the gates when times get difficult. The infrastructure of a smaller fund is leaner than larger hedge funds so the costs of running the business are also lower, potentially giving them greater flexibility to withstand down market environments. Smaller holdings within the underlying portfolios, in comparison to larger funds, also mean they are better able to liquidate in times of difficulty. There is also the reputational aspect events such as gating incur, to which smaller groups can be much more aware due to their greater need to retain investors. Funds that suspend redemptions run the risk of losing investors that will never come back in the good times.
**Lower fees**
Prior to the 2008 crisis, it was fairly typical to buy a single strategy fund at a cost of 2% management fee per annum with a 20% performance fee. Funds of hedge funds’ fees, with the double layer of charges, meant even higher charges. Over the past five years a lot of pressure has been put on hedge funds to lower their fees and streamline charging structures. Today they have to explain why they are worth ‘two and 20’ as opposed to it being the norm. This can be a far easier adjustment for newer funds than more established players, who have already built their businesses on the back of such fee levels. In addition, several managers offer a ‘founders’ share class, which provides certain privileges and/or advantages to early investors such as lower fees – this can include the level of annual charges as well as a lower performance fee.
Smaller funds are more aware that getting investors’ attention in an increasingly competitive space means they must prove they are worth what investors are paying. As such, they are far more likely to be more flexible on charges than more mature funds. In addition, the smaller asset size of their fund means the manager’s interests are more in line with that of the investor, as performance fees make up a more meaningful percentage of overall compensation.
**Refining the choice**
Of course not all managers in this development phase pose the same risks to investors, which is why due diligence in fund selection is so vital. The groundwork needed to assess investment choice amongst smaller funds, though, is not always straightforward. The hedge fund’s business itself must be scrutinised alongside the strategy and the manager.
Let’s start with the manager. Do they have appropriate experience running such a strategy? Gone are the days when long-only managers without formal shorting experience can easily launch a successful hedge fund, but some still try. Whatever their experience, you must be comfortable with the strategy they are employing and it needs to fit into your overall asset allocation plans, ie: a higher returning manager may be one who has a long bias – does that fit into what you are looking for?
Plain vanilla strategies at the smaller end are often a good choice as they are less complex and operationally they can be less onerous when it comes to research.
A manager may be talented and have the ability to generate performance, but they may not be skilled at running a business, which is why understanding the company itself is essential. Today the bar to start a fund is much higher than it once was, but the risks of failure are still just as great.
‘Is the business operationally sound?’ is the fundamental question that must be answered. Who are the key individuals beside the manager and what experience do they have? What service providers does the business use and are they reputable? Has capital been committed? Are they at breakeven AUM?
Many smaller firms have experienced personnel even though they are new businesses. Equally, many do not. For instance, a red flag may be an obscure administrator, or a CFO or COO without prior experience in that role. In the case of all key personnel, reference checks need be done to check on where, when and who they have worked with before.
**The future for hedge funds**
Hedge funds have been decidedly less popular since the crisis and the environment is still challenging for many. This is both good and bad news for family offices seeking new opportunities.
The bar is high for emerging managers, and increased regulations from the US and Europe mean the costs of starting up are also greater than before. Knowing this, managers trying to attract assets must have a strong commitment to make the fund work. They are also more likely to be flexible over fees and provide greater access to information than they once were.
Smaller funds outperform, and outperformance attracts money – finding the right fund early enough could lead to a rewarding, long-term investment opportunity.
