By Peter Urbani , Co-CIO, Infiniti Capital
New or Emerging Fund Managers, defined loosely as those managers who are less than 36 months old, appear to outperform older more established managers by up to 400 basis points per annum.
Understanding why this should be that case is not really that difficult when one considers where new hedge funds typically come from. Hedge fund managers are usually drawn from the ranks of institutional prop(rietary) desk traders who are tired with the corporate bureaucracy or whom have hit upon a particularly good trading idea. These managers leave larger organizations, usually banks and asset management houses, to set up on their own as Hedge Funds.
The best and brightest of them can often attract many millions in seed capital even before they open their doors for business but all of them tend to have one thing in common - as startup hedge funds they hold significant amounts of equity in the funds they manage. Now working for themselves they have a far greater vested interest in generating excess returns for their clients. Hedge funds generally also have high water marks (HWM), based on the previous highpoint of the funds value (NAV), below which the manager earns no performance fees only a much lower fixed fee which is generally just enough to pay statutory costs. It is principally this interest alignment with clients that makes hedge funds so attractive in general.
For newer ('Emerging') managers there are obviously further business pressures and requirements that go along with running your own business. To be sure these do represent additional 'business-risk' associated with startup funds, but there is no additional 'investment- or market-risk' inherent in them. In fact the empirical evidence is overwhelmingly in favour of Emerging Managers having an edge of up to six percent over and above that of more established Hedge Funds.
To mitigate against the abovementioned higher business-risk of emerging managers Infiniti-Capital conducts an exhaustive and very thorough 3 part due diligence process on all funds which includes a Qualitative, Quantitative and Legal & Operational due diligence. This process includes, physically visiting the manager to verify he/she is there, extensive background and reference checks - we even obtain copies of manager passports to verify their legal names. No fund which has not been through this full process and signed off onto our Qualified Funds List (QFL) can be invested in. All members of the investment committee have full veto rights and can fail a fund for just about any reason. In addition, Infiniti partners with third party investment Banks to provide leverage and structuring and these Banks tend to impose their own risk guidelines on the fund and act as risk monitor. In the case of the two Emerging Manager funds run by Infiniti our risk monitor has additionally constrained us from, investing in any manager with less than $20m in assets under management (AUM), less than 6 months of actual not pro-forma track record. Over and above this we limit ourselves to holding a maximum of 10% of any one managers AUM.
The below table, based on Infiniti's proprietary research (1), illustrates the out-performance of Emerging managers at various time horizons ( 3, 6, 12, 24 and 36 Months against their equivalent older managers it also includes the additional element of screening by AUM.)
Various third party studies support these findings and whilst the absolute values may differ the conclusions are overwhelmingly the same.
According to research conducted by Mayer & Hoffman research in 2006. (2)
"From Jan. 1, 2004, through Dec. 31, 2005, 167 "emerging managers" - those who started funds in 2003 and had $30 million to $250 million in assets - outperformed two leading hedge fund indexes. The class of 2003, or the 167 managers measured on an equal-weighted basis, returned 11.39 percent in 2004, compared with the MSCI equal-weighted index, at 6.55 percent, and the Credit Suisse/Tremont investable index, at 5.31 percent."
A recent paper by Professors Jorion and Aggarwal (3) finds that;
"Emerging managers have particularly strong financial incentives to create performance and may be more nimble than established ones. We find strong evidence of outperformance during the first two or three years of existence. Emerging managers, narrowly defined as having a maximum life of two years, generate an abnormal performance of 2.3% relative to the later years. This difference is statistically and economically significant."
A research paper produced by Cross Border Capital in 2001 (4) found that;
'Young' funds outperform seasoned funds after adjustment for risk of failure. Investors should buy 'young' funds in the first three years of their existence.
A study by HFR Asset Management (5) finds that;
"Emerging managers, defined as managers with less than a two year track record, exhibit compelling absolute return profiles and have typically outperformed the overall hedge fund market."
A research paper by Lazard Asset Management (6) found;
"Our conclusion is that despite the biases found in the data, investors may gain enhanced returns by investing in young hedge funds if proper due diligence is completed. Hedge funds under three years of age tend to perform better than do older hedge funds without necessarily adding to the volatility of returns."
Research by Pertrac Financial Solutions (7) last year ;
"Found hedge funds less than two years old produced average returns of 17.5 per cent a year, against 11.84 per cent for those more than four years old, and also had lower volatility. "(Infiniti's Quantitative Research shows 19.65 per cent avg in 1st year versus 13.97 per cent a year avg after 3 years)
In addition, both the largest pension fund in the world - The California Public Employees' Retirement System (CalPERS) and the Teacher Retirement System of Texas ("TRS") invest in emerging managers. Mr. Jarvis V. Hollingsworth, Chairman of the Board of Trustees of the TRS says, "Empirical evidence has shown that over time, emerging managers perform as well, if not better, than traditional firms."
In the face of so much evidence and our own primary research we can only conclude that - Emerging Managers do indeed try harder.
(1) Do Emerging Managers add value? Peter Urbani, Head of Quantitative Research, Infiniti Capital. Dec 2007
(2) The Search for Alpha: Investing in Newer Hedge Funds, Sam Kirschner, Managing Director; Matthew Hoffman, Chief Investment Officer; Ron Panzier, Chief Risk Officer, Mayer & Hoffman Capital Advisors LLC, New York, Published in 'Hedge Fund Monthly'
(3) The Performance of Emerging Hedge Fund Managers, Rajesh K. Aggarwal, Carlson School of Management and Philippe Jorion, Paul Merage School of Business, Published on January 23, 2008
(4) The Young Ones, Cross Border Capital Limited, April 2001
(5) Emerging Manager Out-Performance, HFR Asset Management, Chicago
(6) Alternative Asset Strategies: Early Performance in Hedge Fund Managers, Lazard Asset Management, Chicago
(7) First two years best for hedge funds - FT Article referencing Pertrac study by James Mackintosh, Financial Times, March 26 2007
 |
Infiniti Capital is a Fund of Hedge Funds manager that pioneered the practice of charging a performance fee only. Originating from a Swiss based family office, Infiniti recently underwent a management buyout and is now entirely owned by its senior management and staff. The company runs a number of FoFs including two specialist mandate Emerging Manager Funds on behalf of primarily institutional cleints in Japan and Asia. |