Small Ball: Niche Hedge Funds Outmaneuver Giant Hedge Funds

The Tradex Group – White Paper Series

January 14, 2013

By Richard Travia, Director of Research

Small Ball: Niche Hedge Funds Outmaneuver Giant Hedge Funds

Behemoth - something of monstrous size, power, or appearance, i.e. “The newest SUV is a gas-guzzling behemoth that doesn't even fit in a standard parking space.” – Merriam-Webster Dictionary

Being a behemoth has its advantages – think of Wilt Chamberlain dunking a basketball unimpeded, or a T-Rex cornering a hapless duck-billed dinosaur.

But in the hedge fund world, being small, nimble and unique outweigh any advantages the hedge fund leviathans bring to the table.

Make no mistake; Wall Street is seeing increased allocations in hedge funds of all sizes, as investors embrace the “value-added” benefits of hedge funds. According to Towers Watson, hedge fund assets under management hit $2 trillion at the end of 2011, and should crest $2.6 trillion by 2013.

Obviously, all hedge funds are not created equal, and three critical areas favor niche hedge funds over their larger siblings:

·                     Performance – In the performance vector, alpha is significantly easier to achieve with unique hedge funds.  As such, funds can hire smaller, yet highly seasoned managers.

·                     Liquidity – With vertical funds, given a 30-day notice, over 90% of the portfolio can be liquidated in one week.

·                     Transparency – Niche hedge funds enable potential investors to “look under the hood” and more easily research fund management metrics.

Investors get the big picture on niche funds, as smaller hedge funds are experiencing more substantial inflows, especially fixed-income and emerging market hedge funds. Comparably, larger hedge fund flows have fallen since July 2007, according to data from TrimTabs Investment Research.

Performance the Difference

Performance seems to be the most significant driver - and difference – between small hedge funds and large hedge funds.

A study from PerTrac said that smaller hedge funds (defined as hedge funds with less than $100 million in assets) generally outperformed not only mid-sized hedge funds, but large hedge funds, as well. The PerTrac data has smaller funds earning a 558% return on investment from 1996 to 2011, compared to 356% for mid-sized hedge funds (between $100 million and $500 million), and 307% for larger hedge funds (over $500 million).

Here’s a more complete breakdown of niche hedge fund performance versus large hedge fund performance:

·         From 1996 thru 2010, funds managing less than $100 million had a compounded annualized rate of return of +13.6%, funds managing $100 million - $500 million had a compounded annualized rate of return of +10.87% and funds managing over $500 million had a compounded annualized rate of return of +10%.

         

·         In 10 of the 15 years in that time period, both funds managing less than $100 million and funds managing $100 million - $500 million have outperformed those managing over $500 million. 

·         In four of the five years where both funds under $100 million and funds managing $100 million - $500 million did not outperform those funds managing more than $500 million, funds managing less than $100 million did outperform funds managing over $500 million.  

         

        That general trend continued in 2011, with funds managing under $500 million outperforming those managing over $500 million. Additionally, hedge funds with assets under $100 million outperformed hedge funds with more than $500 million in assets in 12 of the past 16 years, PerTrac reports.

         

What exactly accounts for the outperformance of small hedge funds? Several reasons stand out:

An increasingly level playing field – Historically, conventional wisdom says that larger hedge funds have, given their ample size, more research capabilities. But investment research has become commoditized, and is increasingly as readily available to smaller hedge fund managers as it is to larger hedge fund managers.

The stealth factor – Larger hedge funds, cumbersome by nature, have a size problem. Specifically, big hedge fund managers must accumulate targeted positions without impacting market prices. That often drives up investment prices not only for large funds, but for anyone else buying up shares of a particular stock. Smaller hedge funds don’t have that issue – fund managers can move nimbly, acquiring positions in favored investments without a spotlight shining down on them or paying an unnecessary, and performance-dragging, premium for fund investment holdings.

Faster, better – Niche hedge funds have another “nimbleness” advantage that fuels outperformance. Being “leaner and meaner”, niche funds can move quickly, as market and client needs move dynamically. In addition, since niche hedge funds aren’t as shackled to their asset bases as are larger funds, they can navigate sluggish markets better, particularly where liquidity is constrained, and can capitalize on niche investments and move positions faster than more sizeable hedge funds.

By and large, smaller, niche hedge fund managers, when properly researched, investigated and understood, generally outperform their larger counterparts and the overall hedge fund universe. 

In addition, smaller funds can afford to be more hands-on, and more flexible with their investment strategies. Also, increased competition between service providers has allowed smaller funds to meet operational standards such as:  high quality service provider relationships, requisite asset verification, appropriate wire transfer controls and detailed valuation policies, among others.

In the hedge fund world, bigger isn’t necessarily better, as niche funds carve out a dominant role in the investment industry landscape.

Expect that trend to continue in the years ahead.