Monday, September 16, 2013

Wither Small Hedge Funds?

Ellen Kelleher of the Financial Times reports, Unfair Darwinian churn drowns small hedge funds:
Managers of smaller hedge funds endure the occasional bout of schadenfreude as they watch money wash into their bigger rivals.

The data suggest that, hedge funds with less than $1bn can outperform on average against the industry’s behemoths. This is particularly true when large funds such as Man Group’s AHL and John Paulson’s Advantage Plus and Gold funds, encounter rough patches. But this revelation fails to deter big investors from rushing to take stakes in funds with more than $1bn to their name.

Analyse the numbers and the dominance of the big players looks striking.

As much as $26.3bn in net flows made its way into the 480 or so single-manager hedge funds with $1bn or more in this year’s first half, according to data from Hedge Fund Research, a Chicago-based tracking firm. Attempts at fundraising over the same period yielded dismal results for the more than 7,500 funds with less than $1bn; they managed to collect just $3.4bn in assets on a net basis – a small fraction of what their bigger peers received.

Adam Guren, chief investment officer at Hunting Hill Global Capital, a New York hedge fund with less than $100m under management, blames the rigid due diligence required when an investor takes a stake in a less-established investment. “It is clear the money flow is still going to the largest funds in the world,” he says. “It is a safe bet for a lot of these asset allocators. It is easy for them to walk through the due diligence process.”

George Schultze, founder of Schultze Asset Management, which has $250m in assets, shares this view. “Because of the risks institutional investors have and their fiduciary duty, they rely on consultants who might not be willing to stick their necks out and tell them to invest in smaller hedge fund managers.”

The returns small hedge funds generate, however, showcase the irony of the situation. Over 10 years until the close of this year’s first quarter, funds worth less than $50m provided an 8.5 per cent annualised return; funds with assets hovering between $50m and $250m threw up an 8.3 per cent return; while funds with more than $1bn fared the worst, offering a 7.92 per cent return.

In March, SEI, the hedge fund consultants published a report entitled “Six Ways Hedge Funds Need to Adapt Now”. It suggested that institutional investors are ratcheting up their due-diligence requirements, partly because they are dissatisfied by the high fees and weak returns their investments carry. They require more reporting and documentation, greater detail on valuation and operational dealings, and more guidance from consultants on their investments.
The imbalance between the amount of money going into large funds and their performance heightens feelings of resentment among smaller hedge fund managers. This surge in envy comes at a time when hedge fund managers at the lower end of the scale report being stuck in a Darwinian environment – costs are rising and they face fierce pressure from investors to slash fees.

“These trends are only accelerating the Darwinian churn of attrition, consolidation and creation within the industry’s ranks,” wrote the authors of the SEI study. “Success has become more elusive for hedge fund managers, especially those who are struggling to recoup losses or are just getting started.”

Managers at small and midsized hedge funds report being frustrated by their inability to grow. “They believe the market is biased against them, based on their asset size,” says Don Steinbrugge, a managing partner at Agecroft Partners, a hedge fund consultancy. His employer forecasts that just 5 per cent of funds will attract 80-90 per cent of all net asset flows to hedge funds this year.

As things stand, even if funds boast robust records, investors are reluctant to take stakes in funds that face difficulty growing. “They believe there must be a reason why other investors are not investing in the fund,” says Mr Steinbrugge.

With thousands of funds worth less than $1bn on the market, managers of smaller hedge funds must offer quality and be able to persuade investors of their portfolios’ advantages. Marketing is pivotal to their success, adds Mr Steinbrugge.

“The number-one mistake most high-quality small to middle-sized hedge funds make is not dedicating enough resources to their sales effort to create asset growth momentum,” he says. “Many hedge funds either have only one full-time sales person, or sales is handled on a part-time basis by the portfolio manager, chief operating officer or president of the firm.”

Managers at smaller hedge funds hold out hope that their fundraising efforts will improve if the performance of bigger funds continues to lag.

Mr Schultze makes the case that a fund’s large size can impede its performance. “The largest managers, the ones with $5bn, $10bn, $20bn or $30bn in assets, are generating flat or slightly positive returns,” he says. “Very well-known names in the industry have had blow-ups or subpar performance recently ... It is difficult to generate alpha if you are a very big fund.”

But Ken Heinz, president of Hedge Fund Research, thinks Mr Schultze’s analysis is flawed.

“I am not sure that is true. You can still have funds managing $10bn or more that have strong performance in a particular year.”

Mr Heinz also makes the point that while larger hedge funds still receive the lion’s share of money from investors, the situation for smaller hedge funds used to be far worse, with many seeing net redemptions quarter after quarter. “The situation has improved,” he concludes. “You are beginning to see investors looking at funds with $200m-$500m in assets.”
This is an excellent article which highlights why small hedge funds are buckling as investors almost exclusively focus on the larger brand name funds.

Why is hedge fund Darwinism particularly brutal on smaller funds? There are several reasons:
  • First, the institutionalization of hedge funds means larger funds are able to better address the stringent due diligence requirements of regulatory authorities and investors. Larger funds have more money and are able to dedicate full time resources to fulfill these due diligence requirements.
  • Second, the consultants act as gatekeepers and their business model is flawed.  It's a volume business where they prefer shoving all their clients in the same brand name funds because it's easy to pass these investments through the board and they get to keep their relationships with the larger hedge funds intact. If you're a consultant, are you going to waste your time performing due diligence on smaller funds? Of course not, it's costly and much easier to build and maintain your relationships with the big brand name funds, especially if you are investing in them in a separate fund (huge conflict of interest!).
  • Third, scale is a big issue for large pension funds and sovereign wealth funds investing in hedge funds. Also, after the crisis, many investors are focusing more on liquidity risk. This means large investors are biased toward liquid and highly scalable hedge fund strategies. Why write a small ticket to some small hedge fund with little capacity when you can write a large ticket to a mega hedge fund who can manage multi billions?
  • Fourth, as the article states, smaller hedge funds are not focused on marketing. They are focusing on performance which is a big part of the reason why they are for the most part outperforming the mega hedge funds which have become large asset gatherers. But running a hedge fund is not just about performance, it's also about running a business, and you need to dedicate resources to marketing your fund and more importantly, have a sound marketing strategy. You can be the best undiscovered hedge fund manager in the world but if nobody hears of you, you're cooked!
  • Fifth, there is a herd mentality among large investors who pretty much all invest in the same large brand name funds. Much easier to go in front of your board if some well known fund you invested in is performing terribly and say "everyone was invested in this fund, they had stellar performance in previous years and we were caught off guard by their recent dismal performance." It's all about managing career risk and those allocating to hedge funds rarely, if ever, stick their necks out to invest large amounts in smaller hedge funds because if something goes wrong, they're cooked!!!
These are the main reasons why smaller hedge funds are having a tough time raising money, especially in this environment where large, sophisticated investors are moving toward shunning funds altogether to avoid paying any fees.

I have my views on the hedge fund industry and expressed them when I went over the hedge fund myth and why most of them are coming up short. There is a tremendous amount of hype in the industry and sadly, many investors don't know what they're doing when investing in hedge funds. They get way too enamored by well known hedge fund gurus they invest with and forget all about their fiduciary duty when sitting in front of these "superstars."

But as I've explained in the rise and fall of hedge fund titans, there are no guarantees that today's superstar will be outperforming in the years ahead or vice versa, that someone struggling today can't come back strong. You really need to understand the strategy, the people, the performance and pay close attention to a fund's alpha as assets mushroom or dwindle.

Mario Therrien, senior VP of funds at the Caisse, told me they look at the IRR of every hedge fund they invest in and any potential fund they are considering for investments. "If they don't know their IRR, we don't look at them."

And Ron Mock, the next president and CEO of Ontario Teachers, told me their "sweet spot for hedge funds is between $500 million and $2 billion." Of course, they also invest in larger funds but the performance and alignment of interests are better in this sweet spot. (Note: Wayne Kozun will be taking over Ron's duties as head of fixed income and alternative investments).

What are my thoughts on smaller hedge funds? It will be tough for many to compete in this environment. I see it in Quebec where many hedge funds closed their doors or are struggling to survive. The same thing is going on everywhere. It's a brutal environment to start a hedge fund and unless emerging managers are able to raise $500 million to a billion relatively quickly and maintain a strong performance, they will not survive.

Having said this, large investors shouldn't ignore smaller funds. They need a sound strategy. I would definitely look into giving a specialized mandate to a reputable fund of funds to invest in smaller hedge funds or seed new funds. Just make sure the terms are right so the fees don't kill you. But if pensions and other hedge fund investors do this right and find solid outperformers, this strategy will pay off in the long run as they find new talent and cultivate these relationships ahead of other investors.

Let me end by plugging the services of Rene Levesque of Mountjoy Capital. Rene tracks over 2,500 hedge funds and offers the "hedge fund industry’s most extensive qualitative research, evaluation and ranking platform." You can reach him at

Below, Schultze Asset Management Founder and Managing Member George Schultze discusses hedge fund fees with Betty Liu on Bloomberg Television's "In The Loop." Read my comments on why hedge funds are chopping fees in half. I disagree with Schultze, they are NOT only ones who have "sub-par performance."

And  Howard Marks, chairman of Oaktree Capital Group, said hedge funds will have to stop charging clients 20 percent of investment profits unless they’re at the top of their peer group. Su Keenan reports on Bloomberg Television's "Money Moves."