Smaller managers may be an overlooked source of alpha. Although the risk of fraud and other drawbacks pose real threats, with rigorous investment and operational review, investors may capture alpha that may be forgone when investing in large, more established hedge funds.
Potential Rewards are High
The benefits of investing in an emerging manager can be large if the “diamond in the rough” can be found. Hedge funds operate in the “shadow banking” sector of our economy. Many of the best managers do not register in published databases, and are marketed through word of mouth. The primary advantage of investing in an emerging manager is the ability to gain subscription to the fund with less capital. Large, established funds tend to require larger subscription amounts, if they are open to new capital at all.
Smaller managers may have an advantage because their smaller fund size can make them nimble. This flexibility may allow them to navigate more easily in and out of trades without impacting the markets they trade in. For strategies such as high frequency trading, microcap equities, long/short equity, and even global macro, these benefits can be quite significant. When funds manage large amounts of assets, they lose investment flexibility and may, as a result, not be able to obtain the returns available to smaller managers with lower assets.
Another advantage of smaller managers is often an investment “edge” that may have worn off for their more established counterparts. These advantages, however, do not negate the need to thoroughly examine the manager’s current and future investment strategy. One of the critical questions that should be asked when interviewing a fund manager is asking the manager to walk through a typical trade. Doubts should be raised if a clear source of alpha cannot be identified through a lucid explanation and solid investment rationale. When a manager explains their strategy, it is useful for a potential investor to ask, “Would I live and die by the decisions this manager makes? Does it seem like he would live and die by what he does?” It is likely that a manager who faces the pressure of having to outperform to survive will have stronger conviction behind what she does. The option here is to grow the fund, or if not, face going out of business. This imperative presents the investor in smaller managers with the opportunity to invest in extremely motivated managers.
Due Diligence May Unlock Alpha
The best way to take advantages of the rewards offered by smaller managers, while reducing the risks they pose, is by thoroughly investigating the manager’s investment strategy and operations – both investment and operational due diligence. Unlike their more well-established peers, smaller managers are less “institutionalized” and the investor must determine whether that state of affairs poses too high a risk. The best way to undertake this due diligence is simple: transparency.
For capital allocators to smaller managers, investing in due diligence is key. Research by Stephen Brown et al. shows that approximately 15% of funds fail annually, and that about half of funds fall to half of their initial value within the first 2.5 years of life. This would imply that smaller and younger funds face a greater risk of capsizing than larger ones do. Research shows the cause of over half of failures are related to operational issues, and the research identifies misrepresented performance and wrongfully allocated capital as major factors.
Thorough and capable investment and operational due diligence of smaller managers is the key to unlocking the higher alpha opportunities presented by smaller managers. While lack of transparency can potentially lead to fund failure, it is also the case that smaller managers with top-grade operations may be a particularly rewarding investment. Investment and operational due diligence is, therefore, a source of alpha. According to Brown et al., operational risk and the resultant conflicts of interest may reduce returns by more than 1.5% annually. Conversely, this implies that if rigorous evaluation is undertaken when investing, the benefits may raise performance by that much or more. Brown’s research also shows that funds of hedge funds with the spending capacity to afford due diligence tend to have an edge over those who do not. Thus, direct investors in hedge funds should undertake rigorous due diligence, either through specialist consultants, or in-house.
The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak. This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein. An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk. An investor in hedge funds could lose all or a substantial amount of his or her investment.
Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.
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 Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy. Brown, Stephen J, Fraser, Thomas L., Liang, Bing. January 21, 2008, page 7. This statistic was cited as originally sourced in Brown, Goetzmann and Ibbotson (1999).
 Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy. Brown, Stephen J, Fraser, Thomas L., Liang, Bing. January 21, 2008, page 8. Article cites Feffer and Kundro (2003) as original sources of this research.
 Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy. Brown, Stephen J, Fraser, Thomas L., Liang, Bing. January 21, 2008, page 2. Article cites research performed by Brown et al. in 2004 as original source of research.
 Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy. Brown, Stephen J, Fraser, Thomas L., Liang, Bing. January 21, 2008, page 3.