Emerging Hedge Funds Outshine Established Peers as Investors Revisit Asset Class

As investors again show an appetite for investing in hedge funds this year, emerging managers may warrant a closer look than established firms, research by Preqin suggests.

Preqin examined the performance of what it called ‘small’ first-time funds with less than $300 million in assets under management, and ‘new’ first-time funds with less than a three-year track record.

Both small and new firms posted a higher 12-month, three-year and five-year annualized return than the industry at large, with new hedge funds in particular posting a higher rolling 12-month performance than the wider industry for the past five years. While this outsized performance has historically been accompanied with a higher level of volatility, three-year volatility for the new hedge funds converged with the wider industry, the study found.

New hedge funds returned 14.1% over 12 months, and 12.22% annualized over five years. In comparison, small hedge funds returned 11.91% and 8.98% over these time frames, and the wider industry returned 10.22% and 7.71%, respectively.

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While emerging funds do show higher risk metrics, the three-year volatility for new funds declined to 4.03% in 2017, converging with the 3.7% for all hedge funds. Volatility edged down for small funds slightly to just under 5%.

“After seeing outflows across 2016, improved recent returns have resulted in investor inflows to the hedge fund industry for the first time in five successive quarters in Q1 2017,” Amy Bensted, head of hedge fund products at Preqin, said in a statement. “This has set the tone for emerging managers in the asset class; with the past performance of first-time funds stronger than that of the wider hedge fund industry, now could be a prime opportunity for new hedge fund managers.”

The report comes as new hedge fund launches increased for the first time in a year during Q1, and as investors have shown a renewed interest in the asset class. Investors allocated $10.5 billion to hedge funds in May, bringing YTD totals as of June up to $23.3 billion, according to research firm eVestment. The allocations come on the heels of seven consecutive months of positive performance for hedge funds, which are now up 3.2% YTD as of May.

The inflows follow a 2016 in which investors pulled more than $100 billion from hedge funds, with the fourth quarter of the year seeing the largest quarterly outflow since the financial crisis. High fees and lackluster complaint has been a prominent complaint for investors.

Large established funds often collect a higher management fee—generally determined as a percentage of assets under management—and are often criticized as having less incentive to be compensated for performance as a result. Larger funds may also be limited in the opportunities they can pursue because of the need to deploy larger amounts of capital to have an impact on performance.

Newer funds generated stronger returns than smaller funds, while also witnessing a decline in volatility, the study noted. “This stronger performance may encourage institutional investors to look past the risks of these first-time funds and find opportunities with emerging managers,” Bensted said. “Indeed, the volatility of funds with a track record of three years or less has decreased and converged with that of the wider hedge fund industry, indicating that investors can access the better returns these funds may present with a comparable level of investment risk.”

The study also found that since January 12, new hedge funds have consistently recorded higher rolling 12-month returns than both small hedge funds and the wider industry. However, investors prefer to invest in small funds over new funds. The study found that 72% of active hedge fund investors would consider investing in a small hedge fund, but only 32% would consider investing in hedge fund with a three-year track record or less.

Given the strong performance and declining volatility, new hedge funds might be overlooked opportunities as investors return to the asset class.

Tags: Emerging Managers, Hedge Funds, Preqin, Returns

The UK financial watchdog Financial Conduct Authority (FCA) recently released a stinging report on the domestic asset management industry that cites underperformance, weak price competition, high levels of profitability, and poor communications with clients.

The FCA said that when looking at fund performance for both retail and institutional investors, it found that both actively managed and passively managed funds did not outperform their own benchmarks, after fees.

“There is no clear relationship between charges and the gross performance of retail active funds in the UK,” said the report, although it did find some evidence of a negative relationship between net returns and charges. “This suggests that when choosing between active funds, investors paying higher prices for funds, on average, achieve worse performance.”

It also said there is little evidence of persistence in outperformance, “and where performance persistence has been identified, it is persistently poor performance.”

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The FCA also expressed concern over how asset managers communicate their objectives to clients, particularly for retail investors.

“We find that many active funds offer similar exposure to passive funds, but some charge significantly more for this,” said the report. “We estimate that there is around £109 billion ($141.4 billion) in ‘active’ funds that closely mirror the market which are significantly more expensive than passive funds.”

The FCA report cited “weak price competition in a number of areas” of the asset management industry, and high levels of profitability, with average profit margins of 36% for the firms sampled.

“Firms’ own evidence to us also suggested they do not typically lower prices to win new business,” said the report. “These factors combined indicate that price competition is not working as effectively as it could be.”

Additionally, worse performing funds were more likely to be closed or merged into better performing funds. And when this happened, although the performance of the weaker performing funds improved post merger, the performance of the stronger fund, on average, deteriorated slightly after the merger.

Based on its findings, the FCA has proposed an overall package of remedies “to make competition work better in this market, and protect those least able to actively engage with their asset manager.”

The remedies include:

Clarifying expectations around value for money, increasing accountability through the Senior Managers and Certification Regime (SM&CR), and introducing a minimum level of independence in governance structures

Requiring fund managers to return any risk-free box profits to the fund, and disclose box management practices to investors

Making it easier for fund managers to switch investors to cheaper share classes, “which will drive competitive pressure on asset managers”
Disclosure of a single all-in fee to investors, which will include the asset management charge and an estimate of transaction charges

Recommending that the Department for Work and Pensions continue to review and remove barriers to pension plan consolidation

“We consider that this will increase efficiency, lead to the UK asset management industry being a more attractive place for investors,” said the report, “and so improve the relative competitiveness of the UK market.”

Tags: Asset Managers, Financial Conduct Authority, Returns, UK