Average hedge fund performance has been mediocre at best over the past five years, which is not surprising because most of the asset flows have been concentrated in a small percentage of firms with the largest assets under management. Many of these firms have morphed into asset gatherers from alpha generators by managing significantly more assets than their strategies can optimally handle. It is no wonder that a study done by Pertrac showed that over a 16 year period, small hedge funds out performed large hedge funds in 13 out of 16 years with an annualized compound ROR for the average small fund of 12.50% compared to that of large funds of 9.16%. In 2013 the Barclay Hedge Fund index, which equally weights all managers, was up 11.11%, however the Bloomberg Hedge Fund index, which gives larger weightings to the biggest managers, was up only 7.4%.
One of the major contributors to this phenomenon of a vast majority of assets flowing to the largest managers is the evolution in the hedge fund investment process among pension funds. Both public and corporate pensions are increasingly shifting their hedge fund exposure away from fund of funds to direct investing in hedge funds with the help of an investments consultant. Most consultants tend to primarily recommend only the largest hedge funds in order to reduce headline risk for their clients, and, more importantly, because of the massive amount of assets on which they are advising. Consultants need managers with whom they can invest large amounts of assets in order for such funds to be invested in by a consultant’s entire client base.
Investors should augment the research provided by their hedge fund consultant by performing their own internal research on small and mid-sized managers. This process can be daunting given the fact that, by some estimates, there are more 10,000 hedge funds. One way to streamline this process is by leveraging the resources offered by some of the top third party marketing firms (3PMs) in the industry. Some of the benefits that a top 3PMs may provide to Investors include:
3PM services are free to investors: fees are typically paid by the hedge fund organization. In addition, some of the top 3PMs require their managers to provide their joint clients with a most favored nation status, ensuring they get the best possible terms.
Screening of the hedge fund manager universe. With an estimated 10,000 hedge funds and an opaque market, it can be difficult to identify the highest quality hedge funds. The best 3PMs spend significant time analyzing hedge fund databases, trade journals, and leveraging various industry relationships to identify a broad universe of managers. This universe is then narrowed down by utilizing both quantitative and qualitative screens. Many 3PM firms then perform extensive due diligence on the top funds before making the decision to represent a hedge fund. In some cases, 3PMs represent less than 1% of the firms which they analyze. In addition, if one of the firms they are representing becomes less marketable for any reason, they have the option to stop representing that organization. In-house hedge fund sales people do not have this option; they need to either continue to sell the fund or find another job. In addition, many capital introduction departments of prime brokerage firms are under pressure to sell hedge funds that are big clients of the firm and not necessarily the best hedge fund for investors. Despite the fact that the top 3PMs can be a great resource to help identify high quality managers, investors should always perform their own due diligence.
Easier mangers evaluation. Investors do not like wasting time with managers that are unable to effectively communicate what they do. A good 3PM will help its manager consistently deliver a concise and linear marketing message that identifies the differential advantages across each of the evaluation factors investors use to select hedge funds.
3PMs can offer consulting advice regarding which strategies they think will outperform given the current economy and valuation levels, identification of trends they are seeing among similar investors and where the money is going. 3PMs are in a unique position since they are both doing research on hedge funds across a broad range of strategies, and speaking with thousands of investors about how their assets are allocated and what strategies they currently prioritize.
Unfortunately, the barriers to entry in the 3PM industry are low which leads to significant quality and reputational differences among the hundreds of firms in the industry. Investors should differentiate between top quality 3PMs that consistently represent high-quality hedge funds versus the lower quality organizations. This requires focusing on the top 10 percent in the industry.