By Najy Nasser, Chief Investment Officer of HeadStart Advisers Ltd
According to the English proverb: ‘hunger is the best sauce.’ In investment terms, those with the most to gain from strong performance, will work hardest to achieve it. Hunger can, therefore, be one of the best sources of return. When it comes to harvesting the ‘hunger premium’, getting a headstart enhances the scale of premium on offer.
The hunger premium is perhaps best demonstrated in the hedge fund world.
Research1 has shown managers tend to provide their best performance during their early years. In large part, this is because managers trying to establish a new fund are more focused on providing performance.
Very hungry is very focused, not just on posting strong returns to attract investors, but also on managing risk. The impact of a drop in performance will be felt more profoundly by an emerging manager trying to attract capital than by an established firm. Smaller funds are also more nimble, allowing them to move assets more quickly a nd dynamically. Furthermore, smaller funds can more easily exploit opportunities before they become crowded and the return potential is diminished. The hunger premium is particularly strong where an emerging hedge fund is led by a highly experienced and seasoned portfolio manager who previously worked out of a larger hedge fund or banking firm.
These portfolio managers, which may previously have managed billions of dollars, combine the experience of tenure with the nimbleness of managing considerably fewer assets under management.
When it comes to harvesting the hunger premium, the early bird catches the worm.
Just as nimbleness is important for single managers, it offers funds of hedge funds a headstart in building relationships, securing capacity, founder share classes and better fees. Smaller funds of hedge funds are therefore much better placed to exploit the hunger premium.
Making investments into emerging managers requires experience, particularly in light of the high failure rate and potential for significant rewards. Any fund of hedge funds should be conducting in-depth research and spending significant resources, particularly time, understanding their investments in emerging managers and how they fit into an overall portfolio. That due diligence and experience often means that funds of hedge funds are well placed to make meaningful allocations that move the needle for both the fund of hedge funds portfolio and the emerging manager.
This will be easier for smaller funds of hedge funds given the greater efficiency of conducting such detailed manager research. Large $5bn funds of funds looking to allocate a 5% position i.e. $250mn may not be able to do so given capacity constraints and the size of the emerging manager. A smaller allocation that the hedge fund may be able to accept such as $10mn is rarely worth the larger funds of funds investing the time and effort involved to conduct the necessary due diligence and manager research.
Because larger funds of hedge funds tend to make sizeable allocations, many are effectively ruled out of investing with emerging managers until they have reached a ‘critical mass’ whereby the fund of funds would not represent more than 10% of the total AUM in the hedge fund.
The ‘critical mass’ for hedge funds has continued to increase, not only as overall industry assets have increased, but also because of the growing regulatory burden and demand for institutional-level infrastructure. Larger funds of funds tend to wait until a manager can demonstrate at least six months’ track record within the existing firm.
Smaller funds of hedge funds, which do not suffer the same structural constraints, therefore have an edge in harvesting managers’ strong early years.
The more capacity constrained a strategy is, the bigger the advantage of a headstart. In some cases, the performance potential of a manager may be significantly depleted by the time they hit the radar of large funds of hedge funds. Some quantitative / systematic strategies, for example, have high Sharpe Ratios of around three or above, but are more significantly capacity constrained.
Long term benefits
The advantages of getting a headstart continue to benefit investors over the long term.
Aside from strong performance, the hunger premium has another important element: hungry funds are more willing to negotiate on fees.
Investing with managers from day one often opens the door to founders’ share classes, where managers offer a certain amount of capacity at lower fee levels. That reduced fee level is maintained for the life of the initial investment.
The fee break emerging managers offer can be substantial and very worthwhile to the investor over time, enhancing the hunger premium available and extending its value. To illustrate this let us assume a hedge fund returned 15% net of a 2% management fee and 20% performance fee. If fees are negotiated to 1% and 10% the net return to the investor equates to 17.78%. The effect of compounding over five years would equate to stronger performance to the tune of 25.47%.
There is another, less tangible benefit available to early-bird investors. In many cases future capacity can be secured as part of the initial negotiations, allowing the fund of funds first refusal on additional investment opportunities as the fund grows. Even where that capacity cannot be contractually secured, managers have a natural tendency to prefer investors with whom they have a strong relationship, especially those who showed support early on. Existing investors often have the ability to opportunistically add to their investments even in closed funds as there is virtually always a limited amount of rebalancing by investors, or funds may need to take in a limited amount of capital to cover costs.
As such, the advantage of a headstart includes effectively securing capacity for the long-term as some emerging managers develop into the ‘blue-chip’ funds of tomorrow.
Harvesting the hunger premium
Selecting those managers is not a straightforward task, however.
While nimbleness is critical to the success of both emerging hedge funds and the funds of funds investing in them, tenure is vital in recognising emerging managers with the potential to become blue-chip firms. At the fund of funds level, experience is critical in being able to identify which funds have the odds stacked in their favour and are, therefore, more likely to succeed.
Harvesting the hunger premium requires a speedy, entrepreneurial decision-making process to remain nimble. Succeeding over the long-term, however, requires a wide network of relationships and a tried-and-tested ability to select genuine and sustainable talent in a world of increasing dispersion.
For those wanting to exploit the headstart advantage, experience, strong industry relationships and a well-established, but nimble process are vital attributes, which can only be gathered through tenure and the knowledge born of investing in emerging hedge funds through several market cycles.
Combining a nimble, yet experienced manager selection process with risk-conscious, performance-hungry emerging managers can yield significant results in terms of performance and downside protection.
Compared to the wider fund of hedge funds industry, between January 2009 and the end of 2013 the HeadStart Fund of Funds returned 78.90% versus 26.30% for the HFRI Fund of Funds Composite Index with annualised returns of 11.52% and 4.38% respectively. Over the same period the HFRI Fund Weighted Composite Index of single managers returned 46.56% with annualised returns of 7.55%.
1. Hedge Fund Research 2012, Pertrac 2012