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HNW Investors Should Consider Smaller, Specialized Hedge Funds

Jun 2017 by Caroline Rasmussen

HNW Investors Should Consider Smaller Specialized Hedge FundsIt is widely known that when too much capital chases the same idea, you can get crowding disasters like Valeant and SunEdison. Size is generally the enemy of all investment strategies, and a team that was adept at managing $500 million is likely to find it difficult to manage $3 billion in the same market without at least incrementally lowering the return potential of the portfolio.

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It is widely known that when too much capital chases the same idea, you can get crowding disasters like Valeant and SunEdison. Size is generally the enemy of all investment strategies, and a team that was adept at managing $500 million is likely to find it difficult to manage $3 billion in the same market without at least incrementally lowering the return potential of the portfolio. Apart from the perils of trade crowding, it is simply easier to be nimble putting on and taking off trades that are smaller in size. While some large and established hedge fund managers have performed very well, smaller hedge funds have generally outperformed those with assets under management above $1 billion, as reported by HFRI.

Unfortunately, it is no secret that many managers have allowed their assets to swell well above their optimal capacity (the level at which a strategy should be capped before it hurts performance). Asset management salespeople have a tendency to push strategies that have performed well but may be capacity constrained, attracting assets that further hurt capacity, thereby diluting returns. Of course, it can be a challenge to identify and access hedge funds that are not bloated with assets and have performed well, which by definition tend to take in new capital selectively. But despite a generally acknowledged need for diversification within hedge fund allocations by strategy and size, the conversation often centers on a relatively contained universe of large, established, big-name funds.

Why is it that many investors continue to favor these types of managers? One reason is that consultants, the gatekeepers of institutional capital, as well as advisors, often view small or niche managers as too risky to endorse. It is safer to recommend well-known and generally larger-end funds, or as the old adage goes, "you can't get fired for buying GE".

Another reason is the sheer size of many institutional investment plans. For instance, the California Public Employees' Retirement System (CalPERS) had approximately $4 billion invested in hedge funds at the peak of its program, representing an allocation of less than 2% against its total portfolio of about $300 billion. As noted by CalPERS' CIO Ted Eliopoulos when the fund wound down its hedge fund program in 2014, to make the investment meaningful CalPERS would have needed to invest at least 10%, or $30 billion, simply too large of an asset base to put to work in the space without incurring significant risk.

More specifically, at a 10% allocation across 15 managers, which would generally be considered a reasonable portfolio, the fund’s average allocation to each manager would be $2 billion. Using a generous rule of thumb of limiting its interest in a single hedge fund to no more than 20% of the fund’s overall assets, CalPERS would be restricted to working with managers with at least $10 billion in AUM. This example demonstrates the conundrum faced by many institutional investors – to maintain a hedge fund program of the requisite size to make an impact on overall portfolio results, without comprising too large a portion of any single hedge fund manager’s capital, these investors inevitably end up with either too much diversification or exposure to only very large managers.

While institutional investment plans can effectively become too big to allocate successfully to hedge funds, this is fortunately not the case with the average high-net-worth investor. Qualified investors should take advantage of this to look beyond the largest funds with the strongest brands, to high-performing but smaller managers and more niche strategies.

Especially in periods of low volatility, it is difficult to find much outperformance in highly efficient markets, which by definition comprise deeper and more trafficked strategies such as large-cap U.S. equity. As noted by Ryan Nauman, market strategist at Informa, "If [you’re] really looking to add alpha or achieve outperformance over a benchmark, the asset classes that have typically offered the most outperformance over time are those with less assets that are less efficient". As shown in Figure 1, which lays out the degree to which active managers beat or underperformed each asset class’ benchmark in the last seven years (net of average fees), small cap, international, and emerging markets – all less efficient areas less easily replicated by passive strategies – have tended to outperform. Smaller skilled managers have a competitive advantage in such strategies as large managers' scale precludes playing in these markets, forcing them into the most liquid and highest capitalization securities that do not always yield the greatest return and can be most vulnerable to liquidation pressures during periods of stress.1 For instance, for the five years ending December 2014, frontier market products that exceeded $500 million in AUM underperformed their benchmark by 0.5% annually, while smaller products delivered 5.0% average annual excess, according to eVestment data. Among international small cap products reported in the eVestment database between December 2005 and June 2016, the cumulative excess return relative to the EAFE small cap benchmark for products that were less than $1 billion was 2.7%, versus 1.6% for their larger peers.

Figure 1 - Infographic - Where Active Management Beats Indexing

THE CROWDED PASSIVE TRADE

Just as capital crowding into specific stocks generally does not bode well for the funds engaged in those trades, herd-like market moves can be predictive of an overall market top. The rush to passive index products that we have witnessed over recent years as a result of asset bubbles promoted by central banks around the world has created one of the most crowded trades in history, with more than $350 billion invested in the top two S&P 500 Index funds. Further, over $7.8 trillion dollars are benchmarked to the S&P. According to Bernstein, a unit of AB, passive management will account for over half of U.S. equity assets under management by January 2018, assuming an extension of the growth rate in passive assets over the last six months.

One implication of this overall market crowding is a potentially richer opportunity set for true active asset managers in general, as less investment capital is actually engaged in evaluating fundamentals and performing price discovery on individual stocks. In particular, smaller and more specialized managers free from the constraints associated with the need to deploy massive amounts of capital and able to avoid market segments inundated with index-hugging assets may encounter a more favorable investment environment and, importantly, they also may be better insulated than their larger counterparts from broad sentiment shifts.

Figure 2 - Dispersion in Equity Returns Across Sectors has Increased Since the Election

Today’s crowded passive trade has contributed to an equities rally that is going into its ninth year, the second longest period over the past 70 years without a 20% market decline. Stock market valuations have only been higher in 1929 and 1999. As a result, the next momentum-driven move in markets is fairly predictable from a directional standpoint. At the same time, the fact of being in the mature stages of the cycle means that macroeconomic factors should begin to give way to more stock specific drivers of return. Indeed, we have already seen a decline in correlations and greater dispersion in equity returns across sectors since the election, as shown in Figure 2. These factors are dovetailing to create an advantageous environment for agile active managers with niche specializations.While even the most astute professional investor cannot reliably determine in advance what time periods will necessitate active management, the broad rush into passive, index-tracking products would suggest that now s an opportune time to reevaluate one’s equity exposure. Having that exposure consist entirely of unhedged, passive strategies in the current market is a classic performance chasing approach that, while perhaps easy to sell, may not serve investors well going forward. With a smaller portion of the market paying attention to valuations, high-net-worth investors should reconsider not only hedge funds in general but specifically managers with lower AUM that have delivered strong net performance by specializing in less trafficked stocks, thereby potentially improving overall performance through an increased number of alpha sources while mitigating risk.

This article originally appears in Private Wealth Magazine.

END NOTES

(1) This Time It Really Is Different and Managers Need to Evolve, Fundfire, January 26, 2017, Tina Byles Williams (FIS Group).


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