01/11/2012

Smaller Firms Stand to Benefit From Malaise

Fed up with weak returns from blue-chip managers, institutional investors are poised to increase their allocations to smaller, less-established fund shops.

That’s the consensus among 20 market players who responded to Hedge Fund Alert’s annual industry-outlook survey. While opinions varied as to the extent of the shift, a majority said they expect emerging managers to attract a larger percentage of the capital that pensions and other institutions invest in hedge funds.

“We believe many global leaders in alternatives are planning initiatives that will see their allocations to smaller managers grow,” said Ray Carroll, chief investment officer at Breton Hill, a Toronto global-macro shop that recently landed a $100 million mandate from Calpers.

Following the 2008 financial crisis, hedge fund investors generally gravitated to the biggest, most experienced managers in search of stability and safety. But many of those same limited partners have grown increasingly dissatisfied with the performance of their hedge fund portfolios — even as most managers continue to charge the same high fees and limit investors’ access to their money.

Generally weak returns during the second half of 2011 only heightened investor frustration, a number of survey respondents noted. The average hedge fund ended the year down about 4%, according to various estimates, while the S&P 500 index gained 2.1%.

“Institutional investors will not pay for average and below-average returns,” said Peter Tarrant, head of capital introduction at prime broker BTIG.

Added Carl Versella, chief operating officer at investment consultant HC Associates: “New managers are where true alpha resides, and capital will be put to work more aggressively next year in this area. As we have seen from Galleon [Group] and others, bigger is not necessarily better.”

A widely held assumption is that smaller, nimbler managers generally deliver more “alpha” — that is, performance independent of market returns — than multi-billion-dollar operations. Research has found conflicting evidence on that point. But the assumption was supported by a 2010 study by Haim Mozes, an associate professor at Fordham University Graduate School of Business, and Jason Orchard, a principal at Spring Mountain Capital. After analyzing the returns of more than 16,000 current and defunct vehicles in HedgeFund.net’s database, they concluded that the more assets a fund has, on average, “the lower its alpha generation.”

To be sure, no one expects pensions, endowments, insurance companies and other institutions to turn their backs on blue-chip managers. And in some instances, the new-found interest in second-tier firms is being driven by the fact that several high-flying fund operators have recently stopped accepting new investors.

Still, most survey respondents expect emerging managers — at least the better-performing ones — will find it easier to raise capital in the near future than perhaps at any time since before the financial crisis. Consider the example of Vaquero Global Investment, a small emerging-market credit vehicle that just this month saw its main backer, Omaha School Employees, double the size of its commitment to $50 million (see article on Page 5).

At the same time, many market players expect the recent downturn in performance to put increasing pressure on managers to consider lowering fees and offering other concessions to investors. “By moving ‘downstream’ of the largest fund operators, these allocators are able to forge stronger partnerships with their hedge fund managers and receive more consideration of custom fee or term requests,” said Alan Pace, head of Citigroup’s U.S. prime-brokerage group.

The newsletter’s survey also found general optimism that global hedge fund assets will continue to grow, after taking a hit in 2008 and 2009. On average, respondents predict overall assets will increase by $200 billion to $2.2 trillion at yearend, compared to Hedge Fund Research’s current estimate of just under $2 trillion.

But a number of market players said they expect investors will be increasingly selective about the strategies they back. In particular, they anticipate increasing demand for investments that bear little correlation with traditional asset classes. Beneficiaries might include commodity-trading advisors and funds that invest in so-called catastrophe bonds.

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