Swimming upstream — Standing out in a competitive environment

Related Topics

By A Paris — Following a year which has been positive for hedge funds in terms of performance, startup and emerging managers face an uphill battle as they continue focusing on generating return while strengthening their communication with clients and prospects.

Strong performance within the hedge fund sector as a whole means the competitive environment is ramping up even more. This makes it an even greater challenge for startup and emerging hedge funds to stand out from the crowd.

“It is extraordinarily difficult for startup hedge funds in this environment. A key means of attracting allocators’ attention is through networking at conferences. For now, emerging managers must do virtual conferences and virtual capital introduction events,” comments Michael Weinberg, Managing Director, Head of Hedge Funds and Alternative Alpha, APG. “There may be some allocators, like ourselves, that are willing to do live meetings when permitted and subject to all safety and other rules. Though virtual conferences and networks may be better than nothing they are far from optimal. We prefer live when possible.”

Henning von Issendorff, Executive Partner, Tungsten Capital Management, notes: “Startup managers need more scope and AUM at the outset because margins are lower and the required infrastructure is much higher. With infrastructure I mean the regulatory burden and the technical infrastructure required. As such, they need more staff and have higher fixed cost straight from the start.”

This state of affairs is confirmed across the industry. Thomas Maier, Director at FERI outlines: “Ever increasing regulation is one of the primary hurdles startup managers need to overcome. There is a much higher reporting burden and many forms they need to fill in. In view of this it is also important for young hedge funds to have the right specialists in place. For example, they would need a dedicated risk manager and an operations professional at launch.”

However, despite these challenges, Maier believes the performance generated in 2020 has smoothed the way for startups to some degree: “The time for hedge fund startups is generally quite benign. The general market environment is positive, driven by the fact that investors have money in their pockets and the governments’ money printing exercises also means there is money to be invested. These underlying market mechanics help new fund managers because investors are not paralysed like they were after the 2008 financial crisis.” 

Industry statistics show new hedge fund launches increased in the fourth quarter of 2020 to the highest level since 4Q17. This is according to the latest HFR Market Microstructure Report. “New hedge fund launches continued to rise as industry expansion accelerated into 2021, driven by the strongest performance gains since 2000, as both managers and investors positioned for strong growth throughout 2021. Volatile trends, including an increase in trading volume from retail investors and a renewed interest in strategies focused on both out of favour, deep value equities, as well as stocks with high short interest, have increased idiosyncratic equity volatility in recent months,” details Kenneth J. Heinz, president of HFR, in a press release.

Further, investor appetite for emerging hedge funds remains strong. In Weinberg’s view: “As a long-term investor, our outlook for investing in smaller or emerging managers hasn’t changed. We believe that the best next generation of investors are often protégés of great established investors. These emerging managers learn from the best and often launch their own funds to have autonomy.  In addition, as they are smaller, they are potentially able to extract excess alpha from capacity constrained opportunity sets that the firms they came from may have outgrown.”

Looking ahead, return expectations are muted. Von Issendorff discusses the outlook for the German speaking core of Europe: “Generally expected investment returns are lower which is clearly manifested in the low interest rate environment. But not only are expected returns low, in this context it is also natural to equally expect less arbitrage or alpha opportunity. The means to very efficiently and uniquely harvest alternative beta can also be expected to be more restricted.”

Maier agrees with the return outlook: “Return expectations from young hedge funds are probably somehow muted as compared to the to the recent years. There are also more ‘levers’ to pull, such as regulation, which reduce returns. Nonetheless, it is still true that young hedge funds typically exhibit higher return expectations than established firms. In addition, their return streams are less dependent on general market direction.” 

However, he says the average size of new startups in the hedge fund space has grown over the last years: “In order to run a hedge fund business in a profitable way the break even point in assets under management, ie the point where the fund manager can pay all his bills from fee income, has been growing. The funds needed to launch also depends on the type of strategy. A CTA or quantitative strategy, which is heavily reliant on systems, needs to make larger investments in their infrastructure and operational set up. In the equity space, such a high investment is not necessary. This means CTA or quant startups are typically much larger than equity strategies.” 

Therefore, managers looking to launch a fund can take this into consideration when looking to set up.

The pull of references

From an investor’s perspective, Weinberg explains the changes brought about by the pandemic: “What has changed over the last year is our investment and operational due diligence process. We have had to adapt to the pandemic environment by shifting to virtual meetings in those periods when live meetings were not viable.

“There were windows of time in some geographies over the past year when we were able to have very small in-person meetings. We did this sparingly and in third-party locations while observing safety protocols. Reference checks, which are always crucial, have become more important than ever.”  

These references are vital in the industry, especially in the current context. Maier stresses the importance of startups having a reputable seed investor or accelerating investor: “An accelerator for example doesn’t only provide money, they bring with them their own standards and reputation which act as a signal to other investors to support the company in question.”