Hedge fund investors are drawn to emerging managers because of their potential to generate higher returns, but to what extent do first-time funds do that?

A new study by alternatives data provider Preqin examines the universe of small or young funds to assess their performance, the strategies they use and the investors in these funds.

Investors expect first-time funds to produce robust returns to compensate for the risk they take by investing in them, according to Preqin, as these are likelier than their established counterparts to fail, either because their strategies are untested through market cycles or their small size makes them more vulnerable to capital losses.

The study defined emerging hedge funds in two ways to assess their performance:

  • First-time funds with $300 million or less in assets under management
  • First-time funds with a track record of three years or less

It found that both groups outperformed the broader hedge fund sector over a 12-month, three-year and five-year period.

However, first-time funds with a three-year or shorter track record produced significantly better returns that those with $300 million or less under management: a five-year annualized return of 12.2% versus 9%.

A few of these funds did much better. Volpoint Fund LP, rolled out in January 2016, returned 107.3% in the 12 months to May 2017.

Preqin found that funds with a track record of three years or less were as volatile as the wider industry over a three-year period, and rolling 12-month volatility for the two groups converged this year.

In contrast, funds with assets of $300 million or less, which generate smaller returns over all timeframes compared with other emerging funds, had the highest volatility over a 12-month, three-year and five-year period.

According to the study, “This indicates that investors, on average, may be rewarded with higher returns with lower volatility when investing in first-time funds with a shorter track record, compared with those that have smaller AUM.”

Emerging Managers

On its database of 14,621 active hedge funds, Preqin tracks 867 first-time funds with a three-year or less track record and 1,759 funds with $300 million or less in assets.

Seventy percent of funds with a shorter track record are based in North America, and 15% in Europe and 12% in Asia/Pacific.

Fifty-eight percent of funds with a smaller asset size are in North America, 22% in Europe and 15% in Asia/Pacific.

Fifty percent of first-time funds with a shorter track record and 46% of those with fewer assets employ an equity strategy, compared with 43% for the overall industry. In addition, 16% emerging managers with $300 million or less in assets manage CTAs, the largest proportion across all fund groups.

Established active single-manager funds have a mean minimum investment of $1.7 million, and charge mean management and performance fees of 1.56% and 19.5%.

Minimum investments are lower for both categories of first-time funds:

  • First-time funds ≤ $300 million: $800,000
  • First-time funds ≤ 3-year track record: $1.3 million

Fees are also lower in both instances:

  • First-time funds ≤ $300 million: 1.52% management, 19.23% performance
  • First-time funds ≤ 3-year track record: 1.58% management, 19.49% performance

A recent study showed that hedge fund managers are acceding to investor demands for new fee structures.

Investor Preferences

Although first-time funds with a shorter track record produce higher returns than funds with fewer assets, 72% of institutions active in hedge funds consider investing in the latter, according Preqin. It cited Singapore Management University Endowment as one example.

At the same time, Preqin found significant interest in funds with shorter track records. Its portfolio search tool identified 524 institutions invested in a fund with a track record of three years or less.

It pointed to two Baltimore entities, both with 30% allocations to hedge funds, that have invested in fund with shorter track records: Alvin and Fanny B. Thalheimer Foundation and France-Merrick Foundation.

Preqin reported that 92% of institutions that invest in funds with shorter track records are based in North America.

In contrast, 38% of Europe-based investors allocate to funds with smaller asset sizes. One of these is London-based Clerville Investment Management, which invests in first-time funds with as little as $130 million under management.

— Check out Investor Appetite Drives a Surge in Private Equity Fundraising on ThinkAdvisor.