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Investing early in emerging hedge fund managers can bring a host of distinct advantages, from potential returns and fee structures to broader portfolio impacts. These upsides are rooted in the unique characteristics of these managers, who often have a significant personal stake in their funds, fostering a culture of discipline and rigorous due diligence.
One of the most compelling advantages is the potential for outperformance. Historically, top-quartile emerging manager funds have delivered higher net internal rates of return than their established counterparts. Their nimbleness and focus allow them to capitalize on niche opportunities and market inefficiencies that larger funds may overlook.
Early investors also often negotiate better fee structures and more attractive terms than those available at larger, established funds. These terms, which can significantly enhance net returns over the long term, may not be available as funds grow.
Another advantage is access to unique strategies. Emerging managers often pursue differentiated, uncorrelated strategies that can provide proper diversification in a portfolio, potentially reducing overall volatility.
However, early investment also introduces greater operational and key-person risks, given the smaller size and less robust infrastructure of emerging managers. Diligence is essential to mitigate these risks.
In terms of performance and fees over the long-term, investing early allows limited partners (LPs) to lock in lower fees, co-investment opportunities, and side letters that may not be available later. As emerging hedge funds grow and become more established, they may increase their fees and standardize terms.
The performance persistence of top-quartile emerging managers is also worth noting. While large, established funds have historically relied on their reputation for consistent performance, recent data suggests that repeat outperformance is becoming less likely. In contrast, emerging managers, driven by the need to prove themselves, often show higher performance dispersion but also a greater chance of landing in the top quartile if selected carefully.
In summary, early investment in emerging hedge fund managers can yield significant advantages through alignment of interests, superior returns potential, and more favorable terms, but requires careful due diligence to manage risks. Investing with fund managers from day one often opens the door to Founder Share Classes, where fund managers offer a certain amount of capacity at lower fee levels which is maintained for the life of the initial investment.
Being focused is beneficial in investment, not just for posting strong returns but also for managing risk. The English proverb states that 'hunger is the best sauce.' Experienced and seasoned portfolio managers who previously worked out of a larger hedge fund or banking firm can combine the experience of tenure with the nimbleness of managing fewer assets under management.
Selecting emerging fund managers is a challenging task, requiring both nimbleness and tenure to recognize those with the potential to become blue-chip firms. Experience is critical in being able to identify which funds have the odds stacked in their favor and are more likely to succeed.
Sources: Hedge Fund Research 2012, Pertrac 2012. The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group.
Smaller funds are often more nimble, allowing them to move assets more quickly and dynamically. Early-bird investors may secure future capacity as part of initial negotiations, giving them first refusal on additional investment opportunities as the fund grows. The effect of compounding over five years with reduced fees could equate to a stronger performance of 25.51%, and over ten years the effect could be an impressive 109.15%.
Fund managers tend to provide their best performance during their early years. The emerging managers' alpha premium is best demonstrated in the hedge fund world. Smaller funds can more easily exploit opportunities before they become crowded and the return potential is diminished. Emerging fund managers who develop into the 'blue-chip' funds of tomorrow can offer long-term capacity to early investors.
Smaller funds of hedge funds are better placed to exploit the alpha premium due to their nimbleness and greater efficiency in conducting detailed fund manager research.
Investing early in emerging hedge fund managers can lead to accessing unique strategies, as these managers often pursue differentiated, uncorrelated strategies that can provide proper diversification in a portfolio, potentially reducing overall volatility. Moreover, early investors might Secure future capacity as part of initial negotiations, giving them first refusal on additional investment opportunities as the fund grows, which could compound over time and potentially result in a stronger performance, such as 109.15% over ten years.
