Small but worthy

Opportunity knocks for the private wealth manager with the ability to pick the right start-ups.

Growth in the hedge fund world is unprecedented. And the future remains promising: according to a recent study by Oliver, Wyman & Co and UBS Warburg, European hedge fund assets will grow from E60bn today to E300bn by 2005. Yet despite money flows and the emergence of a new breed of behemoths of the fund of hedge funds world, the industry is still characterised by a plethora of small and vulnerable funds that are unable to access the capital these giants are desperate to deploy. These funds present a great opportunity for private wealth managers. The problem with the hedge fund industry today is that there is too much capital chasing too few managers who genuinely stand up to scrutiny and are able to deliver. The end of the party appears to have been signalled by the exit of some of the funds of hedge funds pioneers. Global Asset Management has been sold to UBS, Ivy Asset Management is now part of the Bank of America, Momentum is now a unit of the giant Italian savings bank, Unicredito. The institutionalisation of the hedge fund world has answered few of the problems that prompted the re-evaluation of the industry’s fortunes by its founders. It has simply exacerbated them. The real issue here is not whether there is too much capital in the industry but that there is too little capacity. Risk-adjusted returns have been pretty satisfactory in the hedge fund industry. With cash and bonds looking decidedly unappealing and equity markets tumbling, the case for investing in absolute return vehicles, that have by and large preserved capital, has become highly compelling. With little light at the end of the tunnel, this situation is likely to prevail and funds of funds will continue to show healthy inflows. Here is where the problem arises. The hedge fund world can be divided squarely into two camps: the “haves” and the “have-nots”. Those who fall in the “haves” have in excess of E100m of assets under management, and can run a profitable, stable business. The “have-nots”, who remain firmly planted in the less than E100m club, are for the large part, floundering with under E50m. These funds fall well outside the radar screen of a meaningful investment from the large multi-manager groups. Precluded from investing in the smaller and often younger funds, which frequently are the source of more consistent and sustainable alpha, the giant fund of funds groups today find themselves scrambling for capacity among a small clique of hedge fund giants, many of which are disguised as funds of funds themselves. Typically, as capital has ballooned, return compression within the core skill set has set in. In many instances, the manager has long since handed over the reigns to younger acolytes and has little to do with the day-to-day management of money. Under these circumstances, and in this harsh climate, many of the once great managers have stumbled. With more than 8000 hedge funds to wade through, finding the diamonds in the rough is a labour-intensive exercise. Conventional wisdom would suggest that a three-year track record, and a predetermined size of assets under management are pre-requisites. Crunching the numbers of a fund whose manager has long since ceased to be at the centre of the investment decision making process is about as valid as electing a political leader on the record of his predecessor. The dynamics of hedge fund investing are after all asymmetrical. Although a relatively new notion, much empirical evidence suggests that early stage funds do better than their more established counterparts. Herein lies the opportunity for private wealth managers. Professional guidance is imperative. One still needs to militate against the risk of fraud through rigorous background checks. Portfolio analysis and monitoring requires a detailed understanding of complex investment strategies. Concentration risk analysis requires similar scrutiny, and leverage and liquidity analysis requires a regular dialogue with prime brokers and other participants in the same strategy. Diversification across several funds within the same discipline may reduce absolute returns, but can significantly enhance risk adjusted returns over time. Simon Hopkins is managing director of Fortune Asset Management and founder of Global Fund Analysis, Fortune’s hedge fund research affiliate

Investors’ guide to early-stage investing 1 Look for strong credentials 2 Focus on skill not size 3 Look for intellectual grasp of risk management (control of downside volatility) 4 Seek third-party references and opinions