Since the Global Financial Crisis, many investors allocating to hedge funds have sought out fund managers with long track records due to the perceived resilience of these firms’ businesses and investment process during challenging market conditions. This preference has led to a concentration of the hedge fund industry’s assets in a small number of large funds. As a result, the 100 largest funds represent more than 50% of the market.1
It has been posited by many market participants, however, that emerging hedge funds – those that are early in their life cycle – are more attractive investments than their larger and better-known brethren. This idea, which we have discussed previously, has largely stemmed from qualitative arguments, but is increasingly supported by academic research.2
This argument received further empirical support in late 2019 when data provider Preqin and 50 South Capital published an in-depth study on the subject. The study established benchmarks of Early Lifecycle Managers and Established Hedge Funds and compared the performance of more than 5,000 hedge funds from 2012 to mid-2019. It is one of the most thorough performance benchmarking studies of its kind to date and the results are clear cut: The emerging manager benchmark outperformed the established manager benchmark in each calendar year, leading to over 350 basis points of annualized outperformance.
Reasons for emerging hedge fund manager outperformance
We see four primary reasons for this outperformance:
Broad Opportunity Set: Smaller funds have the flexibility to invest across the market capitalization spectrum, allowing them to participate in less crowded trades and take larger relative positions in these opportunities. Established hedge funds, meanwhile, may be too large to participate meaningfully in similar trades.
Alignment of Interests: With a comparatively smaller asset base, performance fees, rather than management fees, drive emerging fund revenues. Most emerging funds are not “asset gatherers”; to be successful, they must focus on generating strong, differentiated returns for investors.
Specialty Focus: Many emerging managers specialize in a niche sector or style of investing. As hedge funds grow and become established, they often become more diversified or outgrow/drift from their core competency, which may negatively affect performance.
Self-Selection: Successful emerging mangers tend to ‘self-select’, often leaving established firms and well remunerated jobs to launch their own businesses. Despite the newness of their funds, these managers may be investment veterans. Investors can benefit from their blend of experience and entrepreneurial energy.
Emerging hedge fund managers may be less risky
While it may be contrary to investor perceptions, the Preqin and 50 South Capital study also suggests that emerging managers are less risky than established ones. This may be attributable to emerging managers’ smaller team sizes or specialty focus, both of which could result in the managers gaining a deeper knowledge of positions. Additionally, newer managers without a meaningful track record to fall back on have a particularly strong incentive to avoid a significant drawdown and may manage risk accordingly.
Benefits of casting a wider net
This study quantifies the long-held contention that emerging hedge funds outperform their established peers, and further indicates that they have done so with smaller capital losses. Investors considering an allocation to hedge funds may benefit from including emerging hedge funds within this allocation.
1) Source: Hedge Fund Research, Inc. As of Sep. 30th, 2018.
2) “Size Age and the Performance Life Cycle of Hedge Funds,”Gao and Yin (Purdue University) and Haight (Loyola Marymount University).
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