Choosing hedge funds can appear to be a complicated process, one riddled with different elements that weigh unequally upon the individual's wants. Do people pick them based on returns? How important is the fund manager? What role does the investor want to play? How active of a role? Do they go for familiar names and brands?
Agecroft Partners' Don Steinbrugge, one of the top experts in the hedge fund industry, spoke with Benzinga about the process and psychology behind it.
Hedge Fund Branding And Asset Flows
Benzinga: Are hedge fund branding and asset flows correlated?
Don Steinbrugge: There’s a bunch of different ways to approach hedge fund branding. However, the big picture is that most assets are flowing to hedge funds that have the strongest brands. 91 percent of assets are currently allocated to hedge funds that manage $1 billion or more in assets — which account for only 5 percent of the industry.
On the other hand, hedge funds with less than $100 million in AUM are getting less than 2 percent of assets, despite representing a vast majority of hedge funds in the industry.
Moreover, the concentration to the largest managers has increased over the past eight years as large institutional investors, such as public pension funds and corporate pension funds, continue to represent a larger and larger percentage of the industry. [Now, this concentration derives from the fact that] a number of these pension funds prefer to invest in the hedge funds that are very well known because if something happens to them they can point to the fact that a lot of other people also invested in those funds.
BZ: Can’t this be problematic?
Steinbrugge: Indeed.
I think this is one of the problems of the industry because there are a lot of hedge funds that are managing more assets than are optimal for their strategy; if you manage too much money it is hard to generate the same returns you did when you were a lot smaller and more nimble.
BZ: Can you elaborate on that? I mean, one would assume the more money you have, the more you can allocate to different strategies and diversify your portfolio.
Steinbrugge: So, the way to maximize returns in hedge funds is to focus on inefficiencies in the marketplace, and often those inefficiencies reside on the stock side, with smaller or midcap managers that aren’t as well covered by Wall Street; or, they’re with complex fixed income instruments that don’t trade a lot of volume in the marketplace.
These are the type of securities where, if you do a lot of research, you can get an information advantage over the marketplace and generate strong performance. But, if your hedge fund gets too big, the return you get from your investments in these types of securities is diluted over a larger asset base. So, as you get too big, these types of securities either represent a smaller percent of your portfolio or you stop investing in them all together and focus - on the equity side- on very large cap stocks like Apple Inc. AAPL, or Tesla Inc TSLA, or Metlife Inc MET, where it is much more difficult to get an information advantage, or on larger fixed income deals.
So, the returns decline if a hedge fund gets too large, and I think that is happening to a lot of hedge funds in the industry. In fact, I think that is part of the reason why the largest hedge funds underperformed last year, and are continuing to underperform during the first quarter of this year. There have been studies that show that over very long periods of time smaller managers outperform large managers.
Branding And Small Hedge Funds
The expert then moved on to explicate while branding is especially important for small and emerging hedge funds.
Steinbrugge: Each year, there are two or three very successful new hedge fund launches, which tend to be well publicized, often created from a spinoff of another hedge fund or from a prop trading desk on Wall Street. These hedge fund launches create a buzz and may often launch with over $1 billion in assets — and this is despite the fact that most of them don’t have an audited track record and are brand new organizations.
People are basically betting on their pedigree, that they are going to do well going forward, even though they actually haven’t proven they can generate returns for their own hedge fund.
The flip side is there is a lot of talented small hedge fund managers that do have audited track records, that are three to five years in length, that have been implementing the same process for five years, that have good bios, but are still having extreme difficulty raising money, simply because they don’t have the same brand that other hedge funds have.
How The Get The Most Of Your Money
BZ: So, what should investors do about this?
Steinbrugge: If you really want to generate the highest risk-adjusted return in a diversified hedge fund portfolio, you have to be open-minded; you have to do hard due diligence and try to find those diamonds in the rough.
Don’t just go with the herd. Go with the small to mid-size managers that rank well across multiple factors; or look at the quality of the organization, investment team, investment process, risk control, performance, and high-quality service providers that are under the radar screen of most institutional investors.
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