An ill-advised, persistent and costly error among institutional investors and their consultants is their reliance on large brand name money management firms to look after their assets. We had the privilege of attending and speaking at the recent Emerging Manager 2009 conference, from where we return with some very persuasive statistics that show the outperformance of small money managers over the large mainstream firms.
But first an overview over the universe’s demographics. Emerging managers encompass a wide range of firms. Joanne Infantino of the CFA Institute gave a brief overview over the emerging manager demographic. Historically, the term has been applied to minority and women-owned money management firms with a high degree of employee ownership and have less than $1 bn in assets under management. In the Altura database, the current average AUM is $257 million and average number of employees is 10.3. As a group, they employ over 8,000. Total assets held by emerging managers are $200 bn, representing a mere 1.6% of tax-exempt institutional assets. Michael Moy of Pension Consulting Alliance quotes numbers from Pension & Investments whereby only 100 mega asset management firms control 86% of global institutional assets. The Deal Sleuth believes that such a concentration of market power among so few decision makers should alarm all investors who build asset allocation models under the assumption of efficient markets with atomistic participants. As an aside, attrition rates between established and emerging firms are similar for equity managers, but emerging manager attrition is higher for fixed income.
What counts in the end are risk and return, and by most metrics, emerging managers beat their larger competitors. Even though the margins may seem small, we assume that readers of this space are familiar with the power of compounding over long periods and will not go deeper into this question. Michael Moy shows that even in the over-researched large cap core style box, emerging managers outperform mainline managers and achieve slightly lower standard deviation (see figure below). He also showed that in terms of skewness, emerging managers match mainline institutions. However, they beat mainline managers on kurtosis, where larger firms tend to exhibit long tails, whereas emerging firms have no statistically significant tails.
A similar case as for large cap core can be made for fixed income, except that the advantage of emerging managers on kurtosis is no longer present.
Cesar Gonzales of Progress Investment Management underlined the outperformance with whole range of statistics, of which we can repeat only a few here. Cesar based his analysis on firms in the database of eVestment Alliance. His breakdown of large cap core performance by managers’ firm size show the clear outperformance of small firms:
The information ratio is also much better for smaller firms than the large managers. As a reminder, the information ratio measures a manager’s risk-adjusted outperformance. It is the active return (manager return minus index) divided by the active return’s standard error.
Readers who are still not convinced should consider the down market capture ratio of emerging managers. Anyone who lost a bundle in the recent crash with a large brand name firm would have fared much better with an emerging manager. Firms with more than $1 billion of AUM have captured almost 100% of the downside, whereas niche player with less than $100 AUM have not even captured three quarters of the downside.
These are the statistics for large cap equity managers, and we can extrapolate that the small firm effect should be even more pronounced when we look at smaller market capitalizations. For small caps in particular, where smaller firms can have an edge over big ones, we would expect that the statistics look even more favorable for emerging managers. Cynthia Tusan quoted a 2007 study by Gregory C. Allen of separate account managers that shows that although smaller managers have an edge over mainline firms across the entire capitalization spectrum, the effect is most pronounced for small caps.
The successes of emerging managers are not limited to traditional asset classes and hedge funds. Mary Kelley of Invesco Private Capital pointed out that 21% of all private equity funds between 2005 and 2008 were raised by emerging managers, representing only 6.5% of the committed dollars. Invesco’s Emerging Manager Partnership Index has outperformed the Venture Economics All Private Equity Index, with 60% of all funds achieving first or second quartile performance.
Acceptance of emerging managers by institutional investors is increasing slowly. Mandates continue to be awarded for the most part to the largest 85 firms that each control at least $50 billion in assets, and have grown to a size where they no longer are capable of adding value. Nevertheless, a number of plans have adopted specific mandates to allocate small stakes to emerging managers, and some firms have even rolled out emerging manager funds. Even investment banks are capturing the trend, with Morgan Stanley (MS) reportedly planning to roll out an emerging manager platform. As a result, emerging managers themselves have changed. It is not uncommon today to see small firms backed by larger sponsors, that act effectively like venture capitalists or incubators.
Investors’ motivation for hiring emerging managers goes deeper than mere performance and the quest for alpha. It is now accepted that the high percentage of employee ownership serves as a better incentive for performance than the indirect bonus structure of large firms. In addition, concentration risk of ideas from mainline firms is best countered by diversification of ideas that goes far beyond the top 100 firms. As a result, we expect to see more interest in emerging managers and the development of many more emerging manager programs over the next few years.
Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which engages in merger arbitrage, capital structure arbitrage, proxy fight and distressed securities investments. He is the author of an e-book about alternative strategies as well as the forthcoming book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).