Betting on the Underdogs – Why Niche Hedge Fund Managers Make for Better Investments

The Tradex Group Weekly Blog

May 21, 2013

By Richard Travia, Director of Research

Betting on the Underdogs –

Why Niche Hedge Fund Managers Make for Better Investments

It’s been written about, empirically stated and statistically proven over and over again; smaller, niche hedge funds are the better way to go across the board.  They are often the hungrier managers who are more focused on producing better returns.  Combined with lower risk, better liquidity, more investor friendly terms and ultimately more control for investors, the decision to invest in smaller, niche hedge funds over the management fee collecting behemoths should be an easy one.

Yet read any of the latest headlines and metrics describing where the money flows to hedge funds go, and you’ll see the same thing – the vast majority still clamor for the largest 20% of hedge funds, leaving the other 80% scratching their heads.

Countless studies throughout the last few years have provided concrete data showing funds with lower assets under management (AUM) have outperformed their larger peers.  One of the most highly regarded studies on this topic comes from hedge fund research firm PerTrac, which noted that among 7,157 hedge funds, funds with less than $100 million in AUM generated 360 basis points of annualized performance over those with over $500 million in the last 15 years – a significant spread.  

What’s more, the findings showed that offerings operating for less than two years outperformed those with more than four-year track records by 526 basis points during the same 15-year window.  If there was a way to more accurately strip out survivorship bias, these spreads would likely be even wider.  When (not if) interest rates rise, the underperformance by the hedge fund behemoths will become even more pronounced, highlighting a potentially less liquid, highly correlated, beta driven hedge fund is the investor’s alternative of choice over an alpha-producing, uncorrelated nimble hedge fund.

In addition to their greater likelihood of performing better than larger hedge funds, smaller, niche hedge funds are generally more accommodating to investor demands, especially when it comes to negotiating fees and lockup provisions.  Tradex and its principals have consistently invested in high quality hedge funds early in their life cycles over the last decade and expect to continue to do so because of the obvious advantages. 

Ernst & Young's highly-regarded "Global Hedge Fund and Investor Survey 2012", published late last year, provided supportive data suggesting that investors who expected to increase their allocation to emerging hedge funds, in addition to the prospects of better return profiles, also are more likely to have the upper hand when it comes to negotiating the terms of their investments.

Of the allocators who participated in the study, who on average deploy 5-6% of their assets to small and/or emerging hedge funds, the findings revealed that 27% of those that boosted their allocations to these managers did so because they offered better terms.

Between their abilities to outperform, posing less potential risk and being more readily able to accommodate investor demands for attractive fees and lockup provisions, smaller, niche and more nimble managers should be the investment of choice for hedge fund allocators.

So why are investors still knocking on the doors of the largest hedge funds that they can’t in many cases get in to?  While allocation size likely has much to do it (i.e. becoming the largest investor overnight), much of it has to do with herd mentality and the job security of the allocator.

We think that this has a chance to change, particularly with the JOBS Act paving the way for hedge funds to market and solicit their wares.  Before then, investors would be well served straying from the pack and looking at smaller and more nimble niche hedge fund managers.

Richard Travia serves as Director of Research of Tradex Global Advisors.  He is a Partner and co-founder of the firm, and he focuses on hedge fund manager due diligence and selection while also overseeing the R&D for Tradex’s systematic hedge fund identification models.  Headquartered in Greenwich, CT, and managed by partners Michael Beattie and Richard Travia, Tradex Global Advisors was launched in 2004 and today manages a single hedge fund and several fund of hedge fund portfolios.  Learn more about Tradex at http://www.thetradexgroup.com or follow Tradex on LinkedIn and Twitter.