Emerging hedge fund performance questioned

Hedge fund investment consultants and early-stage fund-of-hedge-funds managers are critical of industry-produced and academic analyses that don't correct for survivorship and backfill biases found in the various public databases that aggregate self-reported hedge fund returns. They contend that statistical studies including these two biases produce artificially high returns for both small/young and large funds. One of the industry's most widely read performance comparison studies, by PerTrac Financial Solutions LLC, showed that small hedge funds — managing less than $100 million — each produced 360 basis points of annualized outperformance over large funds — those managing more than $500 million each — over the 15-year period ended Dec. 31. Over the same period, hedge funds in business less than two years returned an annualized 526 basis points more than those in operation for more than four years, PerTrac researchers found. But PerTrac's most recent analysis of 7,157 hedge funds — created from the merger of five hedge fund databases — didn't correct for survivorship and backfill biases, and the returns calculated by the study are overstated, consultants said. Survivorship bias is introduced into a hedge fund database when a fund closes and its track record is removed, resulting in improved returns overall because the database tracks only successful funds. Backfill bias occurs when a hedge fund includes past performance in its first report to a database. The combination of survivorship and backfill biases accounted for 718 basis points of the 14.88% annualized performance for the 15-year period ended December 2009 of 6,169 hedge funds from within the TASS database that were analyzed by Roger G. Ibbotson, Peng Chen and Kevin X. Zhu. Instant-history and survivorship biases are “inherent in all publicly available hedge fund databases” because there is no standardization of the data requested of hedge fund managers by database vendors, said Lisa Corvese, managing director of global business strategy of PerTrac, a financial software developer. “People rant about these biases all the time, but no one has a good, easy solution for getting rid of them,” she said. The good news for institutional investors is that the small cadre of institutional-quality emerging hedge funds run by experienced portfolio managers has outperformed larger funds over time, just by a smaller percentage than industrywide statistics suggest.

SMALL FIRMS, BIG RETURNS

Based on their own investment experience and analysis of multiple databases, hedge fund seeders and investment consultants agree that this select group of small hedge funds with track records of three years or less outperformed larger funds by an estimated annualized rate of 1 to 2 percentage points over the 10-year period ended Sept. 30, through a combination of alpha generation and discounted fees. Outperformance would be higher if revenue shares, which kick a portion of the new hedge fund's profits back to investors and seed equity stake profits, were added to the aggregate mix. Investors increasingly are ignoring the fracas over data analysis and the lack of public information and are investing with fund-of-hedge-funds managers that don't need to rely on hedge fund databases to find great young managers. Such managers include Protégé Partners LLC, Blackstone Alternative Asset Management, Larch Lane Advisors LLC, Rock Creek Group LP, IMQ Investment Management BV and Pacific Alternative Asset Management Co. LLC. Institutional investors seeking the promising returns of new and small hedge funds include the $133.8 billion New York State Common Retirement Fund; the $490 million Richmond (Va.) City Retirement System; and the New Jersey Division of Investments, which had investment responsibility for $66.4 billion as of Sept. 30. The $37.4 billion Illinois Teachers' Retirement System already has invested $42 million in two early-stage hedge fund managers through its $500 million emerging- managers program and likely will add another new fund next year. The plan also seeks to add more exposure to small or newer hedge funds next year, possibly through investment in a seeding fund.

CALPERS' POOL

The $227.5 billion California Public Employees' Retirement System uses a pool of eight hedge-fund-of-funds managers to run an emerging-hedge-manager portfolio that totaled $1.5 billion as of Sept. 30. “These emerging-manager funds of funds are a value proposition for us. They give us the potential to build a relationship with a small manager within a fund of funds and to occasionally graduate a manager into the direct-investment portfolio,” said Craig Dandurand, portfolio manager for CalPERS' hedge fund portfolio. CalPERS has moved three young hedge funds from the emerging-hedge-fund-of-funds program and into its $3.8 billion direct investment portfolio. In September, the system invested $100 million directly into Breton Hill Capital Ltd., an emerging global macro fund manager which carried with it revenue shares that give CalPERS some of the new firm's profits, a move that Mr. Dandurand said wasn't a sign that the pension fund is setting up a seeding program. Most of the established managers in CalPERS' direct-investment program are small to midsize by design, he said. “I would rather hire a $200 million shop than an $8 billion manager. Small managers are just hungrier and less motivated by asset gathering than they are by performing very well,” Mr. Dandurand said. Large funds such as CalPERS, as well as early-stage, specialist fund-of-hedge-funds managers, are being barraged by a rash of new hedge fund companies seeking institutional cash. But very few new funds make the first cut. “The bar is high,” said Mark Jurish, Larch Lane's chief executive. “Our team meets with dozens of early-stage hedge fund managers seeking capital, the majority of [which] do not have the appropriate infrastructure in place to make it through even the first stage of our process.” Larch Lane managed $1.4 billion as of Oct. 31. Seed investor IMQ Investment Management's business model relies on catching new companies launched by very experienced investment teams even earlier: The firm is involved right from the start as the first investor in the new hedge fund. The IMQubator investment team brings a $34 million seed investment but also insists on taking a 25% equity stake in the new firm, requires a three-year lockup on the investment and requires that the hedge fund portfolio managers work in the firm's Amsterdam office for at least three years, said Jeroen M. Tielman, chief executive and founder. In 2009, a year after IMQubator's launch, Dutch institutional investment manager APG Algemene Pensioen Groep NV invested $340 million in the firm's seeding -program. By the end of this year, the fund will have invested in 10 young European and Asian hedge fund managers, Mr. Tielman said. “The seeding moment is a unique one,” he said, because “as the sole seed investor, you can push for the best governance, the best alignment of terms, and the complete transparency. And because there is such a high reputational dimension for new hedge fund managers, they will give everything to their investment process to make sure it's a success. It's like competing in the Olympics. They only get one chance to prove their worth.” A smaller asset base can be an advantage for hedge fund managers, especially for strategies that are capacity-constrained, said Jeffrey Tarrant, founder and chief executive of Protégé Partners, which specializes in seeding and investing in smaller hedge funds. Institutional investors are starting to look for managers that will diversify their hedge fund portfolios as they realize that there is “a lot of overlap between in the equity portfolios of their large hedge fund managers. Large hedge funds by necessity have had to start fishing in large-cap ponds, even if they used to be small enough to fish in small-[cap] and midcap pools,” Mr. Tarrant said. “Smaller hedge fund managers are far more able to move more nimbly in and out of small-cap stocks but can invest in large-cap stocks if they want to,” he said, adding that small managers tend to stay true to their investment style because they aren't forced by their size to deviate in order to put money to work. Protégé Partners managed about $3 billion as of Oct. 31. Christine Williamson is a reporter with sister publication Pensions & Investments.