…We spoke about the importance of ‘Emerging Mangers’ in our October 2016 commentary and thought it would be a great stand alone piece to share with our more general readers here in our ‘Latest Research’ section.
In the investment management business the term “Emerging Manager” relates to adolescent funds or asset managers that have graduated from the start-up phase but that are not yet so large as to have become institutionally complex. Large enough to survive but small enough to perform, Emerging Managers are at a developmental point in their corporate life cycle where the demands of running the business (e.g. complexity) have not yet subjugated the goals of the profession (performance). Put another way, the investment approach of an Emerging Manager is not yet constrained by market capitalization limitations or by the group-think mentality that occurs when investment decisions are made by a committee whose members are individually divorced from the risks of their actions. By contrast, the Operating Partners or Portfolio Managers of an Emerging Manager will almost always have the entirety of their capital concentrated in their own strategies or funds.
Why is this important? The significance of Emerging Managers is simple: there is a discernible correlation in asset managers between outperformance and size. Taking this a bit further, the optimal window to be invested with a young and performing asset manager tends to be between roughly years 3 and 8, when total assets under management are above $100 million, but below $500 million. Several factors align during this window, some organizational, some structural, which helps to make it a more reliable predictor of success.
Organizationally, the compensation structure of an Emerging Manager is much more conducive to alpha generation than at a mature fund company. For starters, a Portfolio Manager on a billion-dollar fund is making a pretty good living, almost certainly seven figures. This individual is not very likely to risk their career for a few extra basis points of performance and their employer, probably a public company, is tolerant of failure so long as it is conventional. A big decision for a manager like this is whether to have a 6% weight in Royal Bank or a 7% weight. By contrast, the Emerging Manager builds its business on the back of superior performance and risk control, and is hungry to identify exploitable discrepancies in securities prices. The Emerging Manager seeks compelling opportunities across all sectors and market caps, irrespective of benchmarks, and views being different as a necessary precursor, not a career risk.
Over time, a successful Emerging Manager will grow in scale through a combination of performance and new investors, until such time as its activities become constrained by its shrinking investable universe. The chart below illustrates this nicely. If a Canadian Equity Fund manager is restricted from buying more than 10% of a company (the threshold to become an insider), the chart below shows how quickly one’s investable universe in Canadian Equities drops off as fund size grows. Up to this point, a key asset of the Emerging Manager has been its ability to buy and sell securities with minimal price impact, and to take meaningful weights in small companies doing big things. As the manager grows, these advantages diminish and the ability to capitalize on market inefficiencies in smaller market cap companies erodes.
The simple math of asset managers is that larger you get, the harder it is to become statistically different (and therefore have a chance at being consistently better) than your peer group. When the law of large numbers is combined with the lack of incentive to take “active” risk by mature asset managers, it leaves only a small residual opportunity for outperformance, and more often than not, you are left with negative returns on a relative basis. The trend towards ETFs for an average investor who lacks exposure to a selection of top tier Emerging Managers makes perfect sense in this context.
The below chart comes from Eurekahedge, a Singapore-based manager research firm which tracks monthly performance on a database of over 22,000 global funds for institutional clients. This specific chart looks at 16,000 managers in its US-focused database, plotting their annualized 5 year trailing returns against their average assets under management. While there is a lot going on in this chart, the quality that stands out to us is the positively skewed dispersion of returns for managers with between $100mm and $500mm in assets under management, and how the median manager performance peaks around the high end of this range.
From Eurekahedge: “while some of that dispersion is on the downside, we see rich potential in the thousands of funds in the northwest corner of the chart. Specifically, there are more than 2500 funds under $200m with annualized returns over 10%, and only 186 funds over $1 billion with comparable returns.”
Emerging managers tend to have a single focus – generating investment performance. This is partly because they aren’t yet burdened by the administrative complexity that comes with managing scale, and partly because performing is far more important to smaller firms than large ones. In our roles at Aventine we have occasion to interact with all manner of investors and we generally find that if an investor has had a really good long-term experience, it is often because they identified a great manager at an early stage in their life cycle, had the temerity to allocate a significant portion of their capital and then the wisdom to let it compound over many years.
Investment consultants often focus on trying to identify if a manager has an “edge” before greenlighting their allocation to any new strategy. If the best degree of edge is one that is tangible, explainable and repeatable then a true edge is extremely difficult to find, because if it is tangible and explainable then it’s rarely repeatable (due to market forces exploiting it). However investors and capital allocators can rely on the Emerging Manager performance edge as a phenomenon that replays over and over with consistency, within the parameters outlined above.
If you have any questions about Emerging Manager performance trends or would be interested in learning more about the implementation of such a strategy in your broader asset portfolio, we’d be happy to speak with you.