Opportunities Investing with Early Lifecycle Hedge Funds

Below is a summary of the Preqin/50 South Capital study. See the full research paper here.

Emerging manager hedge funds outperform established managers across most sub-strategies. A recent study by Preqin/50 South Capital pegs the spread at almost 4% per annum while enduring only modestly higher risk as measured by volatility. Total cumulative outperformance was 22% over five years and almost 36% over the study’s 7.5 year period.

Why do emerging managers remain subscale despite the disparity in performance? Many studies have focused on this phenomenon because capital allocations to emerging managers are a small fraction of those to established managers. Chief among the studies’ theories is institutional risk aversion, amount of fund capitalization, and infrastructure. Further, the manager’s marketing skill plays a big role in fund growth. Most importantly, this outperformance effect has been shown in several studies * and is widely acknowledged by the investor community.

This dynamic creates attractive, overlooked opportunities for investors. Early investors often receive better fees and terms, adding to outperformance. Since the primary reason to invest is strong returns that are sustained by a repeatable process, seasoned managers at emerging firms are more likely to preserve their investment edge and outperform.

Why do emerging managers outperform earlier in their life cycle versus established managers? While each hedge fund is unique, emerging managers share characteristics that provide a structural advantage. Their investment behavior is driven by a focus on growing their business rather than protecting their stream of management fees. It is simple but not easy.

1. Specialized Focus. Their niche strategies are typically capacity constrained, which helps preserve market inefficiencies and the opportunity for outsized returns.

2. Opportunity Set. Smaller funds can invest across the market capitalization spectrum and participate in less crowded trades that are more material relative to their capital base.

3. Aligned Interests. The success of most emerging funds depends on generating strong, differentiated returns for investors because their smaller asset bases result in low management fees, increasing the importance of performance fees to their revenue.

4. Driven Personalities. Successful emerging managers tend to be individuals who left highly compensated roles at established firms to launch their own businesses. They are typically passionate about investing, entrepreneurial, and seasoned.

5. Risk Aware. Newer managers have a strong incentive to avoid significant drawdowns because they don’t have a meaningful track record to cite. Additionally, their size makes them nimbler, and they may manage risk accordingly.

Read the full research paper here.

* The Preqin/50 South Capital study appears to be the most recent and comprehensive research published: Opportunities Investing with Early Lifecycle Hedge Funds, a Preqin & 50 South Capital Study.

Selected additional studies:

1. Emerging Manager Out-Performance: Alpha Opportunities from the Industry’s Newest Hedge Fund Managers by HFR Asset Management.

2. Investing in Early Stage Hedge Funds, Swiss Hedge, Herbst, Marcel.

3. On Taking the ‘Alternative’ Route: Risks, Rewards and Performance persistence of Hedge Funds, Agarawal, Vikas; Naik, Narayan Y. (1999)

4. The Impact of Experience on Risk Taking, Overconfidence, and Herding of Fund Managers: Complementary Survey Evidence, Brozynski, Torstein; Menkhoff, Lukas; Schmidt, Ulrich (2004)

5. Do Hedge Funds Exhibit Performance Persistence? A New Approach, Boyson, Nicole (2003)