Bruce-Lipnick's  Instablog

Asset Alliance What is an emerging manager?

The criteria for what makes a hedge fund an emerging manager can be different for each investor. Most investors would classify a manager as emerging based on the age of the fund (or the management company as a whole) or on the size of assets (or both). In a recent publication dealing with emerging managers,Barclays Capital defines criteria in terms of both size and age of hedge funds. "Small" managers in their study are under $100 millionin assets, while "new" managers have a track record of less than two years.

We agree that both size and age should be considered separately when classifying emerging managers. Hedge fund managers can remain below $100 million as they build their business and refine their operations. Thus, smaller emerging managers can definitely have a track record longer than two years. At the same time, some conferences that we have attended have included managers from established firms with relatively large asset levels, but with new fund vehicles. So to some extent, an emerging manager, like beauty, is in the eye of the beholder.

Why do emerging managers typically perform better?

The reasons that smaller and younger funds perform better are as varied as the styles and strategies that they employ, but we view the reasons cited by Barclays as being valid with some modifications. Source: Barclays Capital and Srategic Consulting Analysis.Both small funds and young funds (which tend to have smaller AUMs) can capitalize on some opportunities that larger funds cannot. Smaller managers with an expertise in a strategy may be better able to identify and profit from undervaluation of small cap companies, for example. The position size necessary to justify the research and monitoring of a small cap company, for example, might expose a larger firm to liquidity or other risks in such a position. Likewise, in credit strategies, smaller firms may be able to participate in smaller issue sizes than would be profitable for a larger fund. Barlcays notes that "some young funds are newly launched products offered by established fund management companies, which may lend those funds some of the same benefits as large funds." We would add that younger funds may adopt innovative new strategies or new approaches to old strategies that enable them to perform better.

Newer managers may be hungrier, so in order to achieve good performance in their critical early years, they may be more likely to devote large amounts of time and energy to their performance, by, as Barclays puts it "reacting swiftly to market up and downturns, taking opportunities, but also obsessively mitigating losses."

How to incorporate emerging managers into a portfolio

A number of considerations are relevant for investing in emerging managers, particularly for investors who are adding emerging managers for the first time. Younger managers by definition will have shorter track records than more established managers. This may affect the analysis that investors perform to gauge the historical risk of the manager or to compare them to the investor's benchmarks. Allocators should devote particular attention to understanding the manager's strategy and method of execution in cases where the track record is short.

Managers with smaller AUMs may find it necessary to spend a larger portion of their fee revenues on infrastructure in order to achieve the operational quality necessary to satisfy institutional investors. If the manager does not focus enough on such infrastructure, it raises the prospects of increased operational risk for the investor. Many quality emerging managers are aware of these risks and devote considerable thought and effort to mitigating these risks. An investor in emerging managers should pay as much attention to operational issues as they do for established managers.