By Donald A. Steinbrugge,Managing Partner Agecroft Partners, LLC
Average hedge fund performance has been mediocre at best over the past five years, which is not surprising because most of the asset flows have been concentrated in a small percentage of firms with the largest assets under management. Many of these firms have morphed into asset gatherers from alpha generators by managing significantly more assets than their strategies can optimally handle. It is no wonder that a study done by Pertrac showed that over a 16 year period, small hedge funds out performed large hedge funds in 13 out of 16 years with an annualized compound ROR for the average small fund of 12.50% compared to that of large funds of 9.16%. In 2013 the Barclay Hedge Fund index, which equally weights all managers, was up 11.11%, however the Bloomberg Hedge Fund index, which gives larger weightings to the biggest managers, was up only 7.4%.
One of the major contributors to this phenomenon of a vast majority of assets flowing to the largest managers is the evolution in the hedge fund investment process among pension funds. Both public and corporate pensions are increasingly shifting their hedge fund exposure away from fund of funds to direct investing in hedge funds with the help of an investments consultant. Most consultants tend to primarily recommend only the largest hedge funds in order to reduce headline risk for their clients, and, more importantly, because of the massive amount of assets on which they are advising. Consultants need managers with whom they can invest large amounts of assets in order for such funds to be invested in by a consultant’s entire client base.
Investors should augment the research provided by their hedge fund consultant by performing their own internal research on small and mid-sized managers. This process can be daunting given the fact that, by some estimates, there are more 10,000 hedge funds. One way to streamline this process is by leveraging the resources offered by some of the top third party marketing firms (3PMs) in the industry. Some of the benefits that a top 3PMs may provide to Investors include:
Unfortunately, the barriers to entry in the 3PM industry are low which leads to significant quality and reputational differences among the hundreds of firms in the industry. Investors should differentiate between top quality 3PMs that consistently represent high-quality hedge funds versus the lower quality organizations. This requires focusing on the top 10 percent in the industry.