Hedge funds are a skill-set rather than a new asset class, and the skills of the hedge fund manager appear to be the reverse of those of the traditional asset manager. In particular, the most sought after hedge fund managers are those at an early stage of their careers rather than those with an established track record.
This is the phenomenon of ‘emerging managers’, a concept that is anathema to pension fund trustees, who will normally demand several years’ track record. Yet proponents of emerging managers argue that their funds can produced better returns than established hedge funds and with no additional volatility.
For this reason emerging managers are attracting the attention of a number of European funds of hedge funds. Last year Harcourt Investment Consulting, a Zürich-based fund of hedge funds firm that has invested in more than 30 early-stage hedge funds over the past five years, launched Belmont Early Stage, which will invest in and seed emerging and early-stage European hedge funds.
It will initially invest roughly two-thirds of its portfolio with early-stage hedge funds and the remaining one-third will be used to seed start-up hedge funds. The majority of these hedge funds will be based in continental Europe, the Nordic countries and the UK.
This year BrunnerInvest, another Zürich-based fund of hedge funds manager, launched BlueSpring, the first emerging manager fund of funds to be established under Swiss law. The fund has between eight and 12 third-party funds. To be included, a
fund must be no older than 24 months when the first subscription is placed. The target annual return is 15%.
So who are these emerging hedge fund managers? Erwin Brunner, the founder of BrunnerInvest, admits that they are not easy to identify. “There’s no definition of what an emerging manager is. These people are sitting most of the time in big companies. They don’t know their clients and they have no assets. And because they’re good they want to start something themselves.”
He defines an emerging manager as “the manager of a traditional or non-traditional fund who launches his or her own fund and requires seed capital, or a manager whose fund has been in place for only a few months, usually no longer than two years, and whose fund volume is still small”.
Why should investors ignore all the normal rules of prudent investing and invest in managers who are untried and untested? The chief reason is that the younger the funds are the better they perform. Empirical studies indicate that for the most part small funds achieve superior performance to larger funds and start-up funds achieve superior performance to older-established funds.
Brunner cites annualised monthly returns drawn from TASS and TASS CTA databases since 1991. These indicate that funds less than two years old tend
to perform better than longer-established funds.
The figures suggest a correlation between the age of the fund and the returns that can be expected. For six-month-old funds the
average annual return was over 30%. One-year-old funds returned 23%, 18-months-old funds returned 18% and 24-month-old funds returned 16%. Thereafter the returns flatten for the next 18 months before falling again to 12-13% for funds aged four years and over.
Monthly figures from Lazard bear this out. In 2002 the incremental monthly hedge fund return was highest for six-month-old funds at 0.5%. Funds up to one year old had monthly returns of 0.29% and up to two years old 0.11%. Thereafter returns fall markedly to 0.03%, moving into negative territory after less than four years.
To prove that emerging managers perform well, Brunner constructed an emerging manager index based on 10 funds in which BrunnerInvest had already invested at the launch or within the first three years. These included such funds as Colin MacLean’s Edinburgh-based Scottish Value Management (SVM) Highlander Fund, a Europe long/short hedge fund, and William Von Muffling’s Lazard European Opportunities fund.
For this the funds’ annual returns in original currency were applied. Each fund was given equal weight. The index showed that over three years performance was over 120%.
What is the rationale behind the outperformance? Brunner says there are a number of reasons. “There is a quicker decision-making process in smaller start-up teams, and this enables quicker exploitation of profitable market inefficiencies,” he says.
Another reason is that these funds are under-researched and generally unnoticed by other investors. “Emerging managers are often not actively followed by many investors especially the large institutions because they assume the risks are higher. That means that more talent can be bought for less.”
Emerging managers also benefit from launching their funds when the climate is right, says Ken Kinsey-Quick, a hedge fund manager at Thames River Capital, which invests in emerging managers and early-stage hedge funds. “With a few exceptions new funds generally launch when the market conditions are favourable for the respective strategy,” he says.
Another important factor is that emerging managers tend to keep their eye firmly on the ball in the early months of their hedge fund start-up. “Individuals, not institutions, create track records,” says Kinsey-Quick. “The superstar who left to start a hedge fund is still the CIO in the first few years, as opposed to the CEO of a multi-billion dollar fund in later years as the business evolves.”
In the end, the ambition of emerging managers to prove themselves might be the simplest reason for initial outperformance. Philipp Cottier, chief executive officer of Harcourt Investment Consulting, says: “Young hedge managers
are simply more driven to create excess returns against their
larger and more-established peers, as well as increased transparency and liquidity.”
Investing in emerging managers carries risks, as even its proponents will admit. Brunner says that the drawbacks are a short track record - or none at all - and a focus on asset gathering. In the early stages of a hedge fund, asset management operates below its break-even point.
The most dramatic risk is that of a ‘blow-up’, with a serious loss of capital. Yet the risk of a blow-up is less than might be expected. Research by UBS published earlier this year shows that it is rare for young hedge fund to lose a large part of their capital and even rarer for that to happen in their first 12 months. Only one European equity long/short fund closed within a year. Overall, less than 5% of hedge funds go under each year. Of these less than 1% lose more than 25% of their capital.
An important reason is stringent due diligence. Hedge funds must satisfy prime brokers, auditors and regulators before they can interest investors.
The real risk is not loss of capital but the risk of underperformance, says Kinsey-Quick. “We have found that the biggest frustration of trying to capture this young fund outperformance is the risk of mediocre returns rather than the loss of a significant amount of capital. Many new hedge fund managers are so scared of losing money in the beginning that they do not take any risk and therefore produce below average returns.”
What about the riskiness of emerging manager funds? One would expect volatility of emerging manager funds to be relatively high. However, emerging manager funds appear no more risky than other hedge funds, says Brunner. “There is no clear evidence that emerging manager funds have a higher volatility during their early years than other funds,” he says.
This is borne out by the evidence. Research by Lazard using 2002 data drawn from TASS/Tremont, Hedgefund.net and HFR databases showed that the annual risk - standard deviation - was 4.9% in one-year-old funds and 4.5% in two-year-old funds. This compares with 4.5% in the six-year-olds and 4.7% in the seven-year-olds.
However, the risk return ratio of the young funds was better than that of the older funds. One-year-old funds returned 22.4% and two-year old funds returned 18.3% in 2002. This compares with a return of 15.6% from a six-year-old and 15.3% from a seven-year-old.
The risk can be reduced further by investing in a fund of emerging manager funds. Diversification dramatically reduces the risk
from blow-ups. Shrewd manager selection can reduce this further. Brunner says he chooses managers using gut feeling rather than anything else. In the absence of a track record, it might well be the safest method.