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.

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.