Hedge Fund Allocators Need Smaller, Niche Funds To Generate Alpha

Nov 10 2011 | 11:39am ET

By Michael Beattie, Tradex Global Advisors --  For years, the hedge fund industry has been reading about, researching and discussing the outperformance of smaller, niche hedge fund managers versus their larger competitors.  Despite this notion, the majority of new hedge fund inflows continue to be concentrated towards larger funds in the hedge fund universe.  In the second quarter of 2011, approximately two-thirds of new capital went to funds managing more than $5 billion, according to data from Hedge Fund Research.  The funds that have over $5 billion in assets manage approximately 62.4% of total hedge fund industry capital, while the top 10 funds measured by AUM manage over 15% of total hedge fund capital (Source: HFR).  According to Russell Investments, 80% of hedge fund assets are managed by hedge funds with assets over $1 billion.  In order to create true alpha and to have less correlated returns from an alternative investment portfolio, smaller, niche hedge funds must be part of an investment program. 

For the last 10 years, Tradex Global and its principals have built their reputation on identifying and investing in smaller, niche hedge funds.  The outperformance of this group is supported by the numbers released in a recent study conducted by PerTrac.  Smaller and niche hedge fund outperformance was clearly evident in Q3 of 2011 where some of the largest hedge funds, which are widely institutionally held, exhibited very poor performance. Following are the results of the PerTrac study: Impact of Fund Size and Age on Hedge Fund Performance.

  • From January 1996 – December 2010, hedge funds managing less than $500 million far outperformed those managing over $500 million.
  • In fact, over that time period, funds managing less than $100 million had a compounded annualized rate of return of +13.6%, funds managing $100 million - $500 million had a compounded annualized rate of return of +10.87% and funds managing over $500 million had a compounded annualized rate of return of +10%.
  • In 10 of the last 15 years, both funds managing less than $100 million and funds managing $100 million - $500 million have outperformed those managing over $500 million. 
  • In four of the five years where both funds under $100 million and funds managing $100 million - $500 million did not outperform those funds managing more than $500 million, funds managing less than $100 million did outperform funds managing over $500 million.  
  • Funds managing over $500 million outperformed both funds managing less than $100 million and funds managing $100 million - $500 million in 2008.
  • This general trend continued in 2011, with funds managing under $500 million outperforming those managing over $500 million (Funds managing under $100 million were up +1.02% through June 30, 2011, funds managing $100 million - $500 million were up +1.05% through June 30, 2011 and funds managing over $500 million were up +0.83% through June 30, 2011).

Further supporting this view, Tradex Global recently conducted a study on the HFRI Fund Weighted Composite Index constituents.  Of the over 1,900 constituent funds, 38% had positive performance in 2011 through September 30, 2011.  Of those positive year-to-date funds, 86% managed less than $500 million in AUM (Source: HFRDatabase.com)

Sometimes more important than relative or absolute returns, and often overlooked, is the implied added operational risk when investing in a hedge fund managing less than $500 million.  Naturally, hedge funds that manage less assets may not have the resources to allocate towards operations, accounting, compliance and marketing.  Many institutional, endowment or family office allocators may not risk their reputation on or may not have the expertise needed for making investments in smaller, niche hedge funds despite all of the data supporting allocations towards these types of investments. 

Tradex Global believes that smaller, niche hedge fund managers, when properly researched, investigated and understood, generally outperform their larger counterparts and the overall hedge fund universe.  Tradex Global has been thinking out of the box for a decade when making these types of investments, by focusing on hedge funds' infrastructure, service provider relationships, asset verification, wire transfer controls, valuation policies, etc.  As an example, in July 2011 Tradex Global produced and distributed to clients an operational due diligence process review on the cash and position reconciliation process of a hedge fund.  Tradex Global produces these types of educational reviews on a monthly basis.  If a proper due diligence is completed on a smaller hedge fund, the outcome can indeed be rewarding and generally less correlated to the rest of an investment portfolio.

Tradex Global Advisory Services, LLC maintains a Recommended List of approximately seventy-five hedge funds that are primarily smaller, under the radar managers that consistently outperform their larger peers.  The Tradex Global Recommended List is detailed below in a comparison against the HFRI Fund Weighted Composite Index.

Click to EnlargeClick Image to Enlarge

Michael Beattie serves as President and Chief Investment Officer of Tradex Global Advisors, which he co-founded in 2004. He directs all investment activities. Mr. Beattie has substantial institutional trading and private investment management experience, including the co-management of the Select Access family of fund of funds from 2002-2004. From 1987 to 2001, Mr. Beattie was a partner with Virgo, a $100 Million manufacturing company where he was responsible for strategic development and design, as well as for running the company’s receivables book and structuring a factoring credit facility with CIT. Mr. Beattie has been a successful private investor for over 30 years, managing family fund of hedge funds investment vehicles as well as direct investments in diverse asset classes including long/short equity, derivatives, index hedging and commodity futures. Mr. Beattie holds a Bachelor's Degree in Business from State University of New York.

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