A slew of studies have concluded that newer hedge funds have outperformed their more seasoned peers. Table 1 summarises three of these studies (Jen, Heasman & Boyatt, 2001; Tremont/Tass, 2000; HFR, 2000) with adjustments for survivor bias ranging from 2.9% in year one to 0.9% in year six of existence. The left side of Table 1 shows a 700-basis point advantage between funds in their first year versus year seven. Note that volatility as measured by annualised standard deviation is relatively unchanged regardless of the fund's year in business. On the right side of Table 1, the Sharpe ratio, a widely-used measure of risk and reward, is presented for the period 1990-2000. From years one through seven, Sharpe ratios declined about 33% from 3.5 to 2.2, using a risk-free rate of 5%. According to these studies, investing in newer hedge funds was clearly not only more rewarding but also less risky than investing in older funds.
Table 1
The Superior Performance of Emerging Funds (1990-2000)
I. Lessons Learned
As a fund of fund that specialises in sourcing, evaluating and investing in newer managers, we have learned a few things about this particular space.
Size Matters
While new funds may emerge in the same year, some begin life with US$50 million and others with US$1 billion or more. Though having more money is great for the manager, investors should proceed with caution given that performance may be inversely correlated with AUM. As research on the class of 2003 indicates, there appears to be a sweet spot investing in managers with US$30 to US$250 million AUM. We certainly think so. Our average manager has about US$100 million when we first invest.
In a proprietary study done by Mayer & Hoffman Capital Advisors (Kirschner, 2005), managers from the class of 2003, that is, funds that commenced operations sometime in calendar 2003, were compared with relevant benchmarks on their performance in calendar 2004. Our sample of 167 managers was selected on the basis of AUM and primary strategy. Managers under US$30 million were eliminated because of insufficient infrastructure and operational inadequacies including human resources. They represented about 60% of all managers in the class of 2003. A smaller group of managers – with over US$250 million in AUM – represented about 10% of the class of 2003, were eliminated as being outliers who were simply already too large to be considered emerging. Another 10% were eliminated for being long-only, multi-strategy, short-only or unclassifiable. Our sample then represents about 20% of the class of 2003 and Table 2 shows the breakdown of the managers by strategy and assets under management. Note that equity long/short is about 35% of the sample group, which is consistent with their representation in the larger hedge fund universe.
Table 2
Emerging Funds Universe Class of 2003
How did this representative sample perform in 2004 in comparison with their larger peers? We selected the MSCI investable as proxies for the hedge fund peer group because they are investable, only contain very large and very established managers, and are calculated and presented in both asset-weighted and equally-weighted versions. None of our emerging managers was found in the MSCI.
Table 3 shows performance comparisons with both the asset-weighted and equally weighted MSCI investable indices. In both instances, the new manager sample outperformed by at least 400 basis points or about 55% in a year where good performance was hard to come by.
Table 3
Class of 2003 Performance vs MSCI Hedge Fund Indices for 2004
All New Funds Are Not Created Equal
We found that the best new funds are started by existing fund families, by managers who have formed strategic relationships with existing funds so that they can use their infrastructure and platforms, and by manager experienced in a particular strategy who have graduated either from other successful shops or from brand-name proprietary desks. Managers with little or no business acumen, those who are migrating to a new strategy, and those without brand name auditors, administrators, and top-level CFOs need not apply.
Who Come With Long-only Experience Are High-Risk Propositions
Ever since Jeffrey Vinik and Michael Gordon left Fidelity to start Vinik Asset Management, a host of long-only managers have followed in their footsteps. "Why work for peanuts," they must have thought, "when a hedge fund structure could pay millions?" With these and related hopes and dreams, successful managers like John Muresianu (Fidelity) and John Schroer (Invesco), started their own hedge funds. What happened? Vinik was successful for about four years and then returned all investors' capital in 2000. Schroer and Muresianu closed their respective shops, Itros Capital and Lyceum Partners, in early 2005 (Infovest21 LLC, 2005). Without experience on the short side, long-only managers are pressed to learn on the job. And the market can be a harsh teacher.
II. Due Diligence Best Practices
Due diligence of new funds is somewhat more specialised than with older and more established funds. First, quantitative analyses are generally not useful on new managers since there aren't enough data points from which to draw conclusions. In general, given only monthly returns, two years of data are the minimum that statisticians consider meaningful in making peer or benchmark comparisons. Therefore, we emphasise the qualitative and operational aspects of due diligence.
A. Qualitative
There are several areas of investigation that, in our view, deserve more attention than others. For the purposes of this paper we will focus only on three: career track record, quality of the team, and portfolio management and trading skills.
1. Career Track Record
Interview the managers' former employers and colleagues. Find out if they had profit/loss responsibility with real money or were only salespeople. Even more critical is interviewing fellow traders. Finding out how they are viewed by competitors on the trading floor can give you insight into the managers' integrity and trading acumen. Often, when new managers spin off from existing funds, their former bosses will invest US$25 million or more to get the fund started. This vote of confidence tells you much. When Goldman Sachs gave US$300 million to Eric Mindich, the firm's youngest partner ever, it ensured that the fund Eton Park would launch in style. Indeed, Eton Park raised over US$3 billion in 2004, its first year. And with a sub-par return in his first full year, Mindich still has to prove he can make money for his investors.
2. Quality of the Team
The people risk, as venture capitalists call it, is substantial in hedge funds. Has there been a fracture in the founding partner group? Has there been litigation? Has the team worked together before or is this the first time? Is each member of the team playing to his or her strengths and skill sets? Who is the CFO? Who is running operations and how much hedge fund experience do they have? How much their net worth have they invested in the fund? As an investor, you should walk away from these interviews with a distinct feeling that the manager and team are decent people with high integrity who are on an aligned mission to succeed and make money. If you have any doubts or your gut tells you otherwise, don't invest.
3. Portfolio Management and Trading Skills
While much can be written about this topic, we will limit ourselves to one aspect: failure. We all know that different hedge fund strategies require differing trading and portfolio management skills. What is less well known is that these skills are often learned as a result of making serious mistakes that caused the manager real pain, both psychic and financial. We like to ask about these failures. What happened? What did they learn? How did they change their risk controls? Did they make changes in their team? How were they transformed as traders or PMs? Be sure to ask these questions. You want to know that your manager has truly learned from his or her errors. The best ones always do.
B. Operational Due Diligence
Does this mean that selecting these new managers is easy? Hardly. A recent report shows that younger funds are more likely to fail in their first few years of operation. The HFRI (2005) review of 564 managers demonstrates that mortality rates reach their peak in year three (14.50%) and then diminish by more than 50% to 6.39% in year seven.
What do we know about the variables that may be responsible for the demise of these young funds? Capital Markets Company (2003) found that operational failures were the number one contributor followed by investment-related issues. Over 56% of the funds failed because of operational and business issues, while 38% reported the primary reason for failure as performance related. Four key operational issues were cited: false reporting of valuations; misappropriation of funds through theft; style drift; and inadequate technology, side controls, and human resources.
At Mayer & Hoffman Capital Advisors LLC, only one person can veto a potential investment at the Investment Committee: the Chief Risk Officer. It is his job to conduct operational due diligence on every potential investment and he has developed a thorough evaluation process and accompanying scorecard that uncovers the types of operational issues mentioned above.
The authors are partners at Mayer & Hoffman Capital Advisors LLC. The firm creates and manages global multi-manager funds of hedge funds focusing on newer and emerging managers and specialised funds. A complete list of the references cited is available from skirschner@mayerhoffman.com or by calling 1 212 400 7872.
