Finding and assessing emerging fund managers is an area that has recently risen up the agenda of the Association of Professional Fund Investors, APFI.
There are a number of reasons for this, such as how to respond to increasing use of passive funds/ETFs for efficient markets in contrast to inefficient markets; increasing consideration of transparency and negotiating power; and increasing consideration of the cost pressures facing the industry, including the impact on costs for accessing alpha.
There are a number of benefits associated with looking to small/emerging managers, according to the views of APFI's members:
- In inefficient markets, that often match satellite allocation, "performance oriented" managers are preferred to "asset gatherers", who thrive on fixed fees and have no incentive to move too far from the benchmark;
- Seeding emerging managers is rewarding as it is proven that they tend to have higher returns compared to established managers;
- Early investors get better transparency and negotiation power, making the investment easier to monitor and more cost efficient;
- Emerging managers may take a more core role in portfolio allocation mixed with passive strategies that can provide cheaper beta, as access to newer, niche ideas can provide alpha at better value;
- Active equity allocations are best made with high conviction managers who are investing longside their clients, which are disproportionately (though not exclusively) to be found among boutique/emerging managers;
- Emerging managers can generally be sourced at relatively lower fees; They are generally capacity conscious unlike larger peers and hence tends to be more disciplined when it comes to closing a strategy especially when size becomes a hindrance to alpha generation;
- With respect to active management it is only emerging managers that are small enough to be able to take significant active share as they are not forced to hold the entire market due to size;
- The new distinguishing source of alpha is now behavioural alpha which investors are more likely to more correctly assess from an independent emerging manager than from a portfolio manager working for a huge corporate whose independence is compromised by huge team dynamics;
- Emerging managers' interest are by far more aligned with those of their investors as they have "skin in the game", are invested alongside their investors and only have good performance to stand on as they can't compete against the huge marketing budgets of large long-established managers; and
- Astute emerging managers have also identified a sincere incorporation of ESG factors into their investment processes as a key source of distinguishing their value proposition from that of large longestablished managers.
However, in the current environment of ever increasing compliance requirements and other operational challenges facing fund and asset management providers, there are also challenges to consider when looking to emerging managers, APFI's members note. These may include:
- High operational risk, therefore it is worth considering such managers incorporated into multi-boutique firms, that provide them with solid infrastructure, seed money for new products and capital while leaving them investment authority;
- Awareness of the need for deep operational due diligence in order to mitigate/control risks, liquidity, concentration risk, counterparty risk and general governance processes;
- ESG considerations may not to be a ‘day 1' concern; Ensuring sufficient analysis of the corporate structure and remuneration schemes;
- Gauging the team dynamic and its effect on performance or sustainability of the fund;
- Recognising that evaluating emerging managers is a more laborious and hands-on process and that allocators with limited or ill-suited human resources will likely struggle to be very successful in allocating to them without more experienced hands to advise them; and
- Understanding that if the inefficiencies an emerging manager targets are arbitraged over time, how they will adapt/evolve for continued alpha generation.
The Association of Professional Fund Investors (APFI) is a registered Swiss nonprofit, all-volunteer organisation exclusively composed of and led by professional fund investors. Founded in 2011, it serves members on six continents.
For more information visit www. profundinvestors.org.