Despite their excellent performance, smaller hedge fund managers need to demonstrate scalable platforms to better compete with brand-name managers.
Following a turbulent Q1 2020 for many managers, hedge funds quickly recovered their composure by producing excellent performance off the back of the COVID-19 volatility. According to Hedge Fund Research, the industry returned 11.6% in 2020, after suffering an eye-watering contraction of 11.6% during Q1.
Hedge funds are continuing to deliver strong returns in 2021 which is translating into significant inflows and new launch activity. However, the bulk of these inflows are being apportioned to the larger $5 billion plus managers rather than the smaller, sub $1 billion investment firms. It is clear institutions are taking a safety-first approach to investing by favoring large managers. While the old idiom that ‘nobody ever got fired for buying IBM still rings true today, it is not always strictly applicable to hedge fund investing.
Smaller hedge funds produce outsized returns
Separate analysis also found that $100 million hedge funds produced cumulative returns of 558% between 1996 and 2011, versus 307% for managers with an AUM greater than $500 million. There are a number of different reasons as to why smaller hedge funds deliver superior returns versus larger managers. Some argue that as funds get bigger, so does the income from their management fees which disincentivizes them from improving performance.
Others point out smaller hedge funds are more agile, allowing them to weave in and out of positions without impediment or alerting the wider market to their movements due to the size of transactions, something which is not always possible at larger firms. Despite the performance benefits that smaller managers confer, a number of institutional allocators are opting for the safety of larger hedge funds.
This investor bias towards larger hedge funds is primarily driven by risk considerations, insofar as many institutions believe that sizeable firms tend to be safer, something which is definitely debatable, especially if the smaller managers in question are organized in such a way where they are surrounded by and serviced by an institutional ecosystem. Another barrier is that large institutions will often write big-ticket allocations, precluding them from investing into small managers lest they end up quasi-owning the fund itself. Similarly, some large institutions do not want to invest the time into conducting intensive levels of operational due diligence on small managers, especially if their performance will only have a fractional impact on their overall portfolio returns. However, by shunning small hedge funds, investors are missing out on admirable outperformance at a time when their liabilities are rising in an environment where interest rates remain near-zero.
Given the current macro circumstances, it would be prudent for investors to reserve a fixed percentage of their portfolio allocations for smaller hedge funds. There is also a compelling diversification argument to invest in smaller managers as many of these firms have navigated the recent market dislocations very well. With investors looking to diversify their holdings amid the volatility, they should consider boosting their exposures to small, and emerging, hedge funds.
Getting the institutional mandates
Hedge funds with limited AUM are often at a disadvantage when capital raising relative to established firms. Boasting strong returns is unlikely to be enough in isolation to win mandates from large, conservative institutions such as pension funds, insurance companies or sovereign wealth funds. Such investors want managers — irrespective of size — to have institutional-level operational infrastructure.
However, investing into cutting-edge in-house systems and processes is prohibitively expensive for smaller managers, especially as many are already spending meaningful sums on regulatory compliance, while simultaneously facing downward fee pressure from investors. This is prompting more managers to outsource non-revenue generating activities such as compliance, and research and analytics, together with the CFO function to third parties. By externalizing these activities to leading service providers, it will enable hedge funds to generate cost synergies as the fees charged by vendors are potentially variable, in contrast to the higher fixed rates managers would typically pay if this work was carried out internally. Moreover, outsourcing lets managers focus on their core competences, namely overseeing client money and producing alpha.
Laying a foundation for growth
In order to maximize efficiencies, hedge funds should consider consolidating wallet share with universal banks that can provide them with a range of different services under a single umbrella including prime brokerage, financing, FX hedging, fund administration, middle office, global custody, and a myriad of other global banking and domiciliation services.
If smaller managers are to be considered for institutional mandates, they need to make sure they partner with service providers who can enable them to meet evolving investor demands. Furthermore, if managers are to pass basic investor operational due diligence tests, they must demonstrate to prospects that they are closely monitoring their vendors’ performance by benchmarking against pre-agreed KPIs. By collaborating with high-quality and well risk-managed banks, which utilize best-in-class systems and technology infrastructure, smaller hedge funds will be able to scale up their businesses to a more institutional standard, thereby helping them to win mandates from sophisticated investors. Hedge Fund Research (January 8, 2021) HFI extends surge to conclude 2020  Forbes (October 23, 2020) Small hedge funds are outpacing their larger rivals  Wall St Journal (December 7, 2020) Some small hedge funds reap big gains in tough times  Financial Times (October 28, 2012) New data shows small hedge funds do better