Traditionally, allocators and investors often eschewed smaller, specialist hedge funds in favour of the firepower offered by larger brand-name managers. But as many smaller funds have posted outsized gains in recent years – while well-established marquee names experienced decidedly mixed performances – many at the forefront of the industry are detecting a potentially decisive shift in investor sentiment.
Traditionally, allocators and investors often eschewed smaller, specialist hedge funds in favour of the firepower offered by larger brand-name managers. But as many smaller funds have posted outsized gains in recent years – while well-established marquee names experienced decidedly mixed performances – many at the forefront of the industry are detecting a potentially decisive shift in investor sentiment.
Squeezed returns – along with fee pressures, investor outflows, increased transparency, greater operational due diligence, and a growth in rival products such as private equity – have thrown up challenges to hedge fund strategies of all stripes and sizes, shifting the balance of power from managers to investors.
As allocators increasingly recognise the need for a more a diversified manager pool to achieve their target returns, rather than simply pouring assets into the biggest names, industry participants believe this evolving landscape offers more nimble, specialist strategies an opportunity to seize on investors’ hunt for yield.
“If you have investor capital that is willing to take those risks, then I do think that there is interesting performance to be generated,” Kenneth Heinz, president of Hedge Fund Research, says of the investment opportunities offered by specialist managers.
Speaking to Hedgeweek recently in London, Heinz observed how smaller managers often offer exposure to newer, more innovative strategies and less crowded trades. Such funds may be running capacity-constrained funds in often niche and specialist markets – but they have demonstrated consistently strong risk-adjusted returns. “All of that is very well received,” Heinz added.
Meanwhile, Pavel Mamai, who runs London-based ProMeritum’s USD350 million emerging markets-focused strategy, believes there is a broader disillusion with the performance of large funds stemming in part from the deterioration in global liquidity following the 2008 financial crisis.
A surge in artificial intelligence and systematic funds within liquid markets such as FX or US equities have eroded margins among conventional long/short funds, while those operating in less liquid markets have faced a squeeze from lower-cost alternative products, such as ETFs.
Kirkoswald Capital, the global macro shop led by former GLG and Moore Capital Management star trader Greg Coffey, is one larger manager reportedly set to close to new money this year. The decision follows Moore Capital founder Louis Bacon’s decision to return capital to investors last November, amid disappointing results and client pressure on fees.
“There are still obviously high-quality firms who continue to thrive, but a lot of them don’t want to accept new capital,” observes Mamai, whose fund which has recorded five years of positive returns since its 2015 launch.
As a result, allocators have begun to re-examine their stance towards smaller strategies such ProMeritum’s, which Mamai describes as “proudly capacity-constrained”.
“For the very, very large funds, they typically need to stick to very liquid products and markets – and so there’s a lot of competition there,” he explains “We are outside of the typically liquid markets. But when you’re outside of liquid strategies and products, if you get very big you cannot trade around your portfolio. You cannot get in and out of themes.”
Despite the attractive gains offered by many specialist funds, what doubts continue to linger among potential investors?
Some believe the push towards the increased institutionalisation in the industry squeezes out smaller, start-up managers who may unfairly be considered less operationally robust.
Strategists at Lyxor Asset Management suggest bigger hedge funds tend to be better equipped to deal with rising regulation, compliance and risk management costs. In a recent research note, Lyxor also noted firms with larger asset bases typically enjoy greater negotiating muscle in the continued wrangle with investors over fees.
“In a world of lower growth and lower rates, fees and costs have become key performance variables,” Lyxor said. “In a more challenging environment for asset raising and alpha generation, larger funds may have now more arguments and means to attract and retain talents.”
Heinz also cites fees as a challenge for smaller names, along with concerns over asset-gating.
“People often think that the success of launching a fund hinges, full-stop, on the ability to generate performance. But performance is only one of a number of things that allows a successful fund to continue after launch,” Heinz says.
“The ones that people might not think so much about and things that really discourage people from investing in newer funds are high fees – definitely an obstacle.
“But something that is not talked about as often is illiquidity, with regard to gating and lock-ups. I’ve heard from many investors that it’s tough to invest in a small or midsized fund, but if there is a liquidity risk associated with that, where there’s a 12-month lockup or gate, those create hesitation among investors.”
Similarly, one London-based service provider noted that although investors are increasingly willing to engage with smaller in on the strength of their impressive performance, the constraints on capacity means big institutional allocators are wary of having a disproportionately large investment in smaller portfolios.
Mamai concedes that it “takes a number of years for institutional investors to change their approach” to smaller funds. But the greater institutionalisation of the business beyond the old ‘two-men-and-a-Bloomberg-terminal’ model common in the late ‘90s and early 2000s is helping to bolster start-ups.
“Operationally, we’ve had comments from investors that our level of institutional framework is absolutely sufficient – more than sufficient – for a firm of our size,” he adds.
For Lyxor, smaller funds’ flexibility has been a key advantage in being able to move capital faster. “More dependent on variable fees than on management fees, managers bear greater pressure on performance and tend to show more ‘animal spirit’,” Lyxor added. “Their reduced impact on market liquidity also allows them to access a wider spectrum of niche and specialised segments.”
In that sense, it is perhaps the nimble, unrestrained approach and often eye-catching returns of many smaller specialist funds that more closely chime with the innovative, pioneering nature that has long defined the hedge fund industry.