Why newer funds can help you outperform

Choosing an emerging manager can help to tilt the odds in your favour when it comes to picking the right fund.

What is the most important factor when it comes to picking a winning fund? If you think it’s about backing the right fund manager, you’re only halfway there.

As investors we’re taught that time in the market is more important than timing the market. Whilst that is undeniably true, there is another key factor that can help to tilt the odds in your favour: invest early (i.e. before a fund manager has become well known in the investing community).

As we’ll reveal in this article, the data shows that newer funds tend to outperform their older, more established rivals. We’ll talk about why this happens later, but to provide you with more context we’ll first look at a high profile example of why investing with the right fund manager at the wrong time can prove costly.

Tiger Management

Julian Robertson was one of the founding fathers of the hedge fund industry. He built Tiger Management into one of the most successful hedge fund managers of the late 20th century, and seeded an entire generation of “Tiger Cubs” in the process.

Robertson’s hunt for hidden opportunities took him to places such as undervalued small caps and “forgotten markets”, whilst he shunned areas of the market where he believed sentiment had driven valuations up to unrealistic levels.

This contrarian approach helped Robertson outperform high-profile peers such as George Soros and Michael Steinhardt. Tiger Management returned an astounding 31.7% per annum (after fees) since its inception in 1980 to its peak in 1998. Assets under management (AUM) reached a massive $22 billion at their peak before losses from tech boom shorts and failed macro bets led Robertson to close the fund in 2000.

However, even after these losses Robertson’s record remained intact. Over the 20 years from 1980 to 2000, his average performance was 26% per annum. Yet despite this formidable record, it is likely that Robertson’s Tiger funds actually ended up losing money for investors overall. This is because Tiger attracted most of its inflows after the peak of Robertson’s success, and although the gains in the early years were astounding, they were achieved on much lower AUM.

Emerging Managers Outperform

This example illustrates an important point for fund investors: emerging managers tend to outperform their more established peers, particularly in their first two years of existence.

This is a well-documented phenomenon. A study from Hedge Fund Research Inc that tracked 564 managers demonstrated that hedge funds in their early years tended to outperform funds in their later years, with higher risk adjusted returns in the first and second years.

What’s more, when examining new funds launched by new fund managers compared to new funds launched by established fund managers, both showed early stage out-performance. However, new manager funds typically outperformed the established manager funds over similar time periods.

Similar results have been documented from the mutual fund sector in a 2014 study published by the National Bureau of Economic Research. The study found that funds that were less than three years old beat their respective benchmarks by significantly more than funds that were 10 or more years old beat theirs—by an average of about one percentage point a year.

These statistics are remarkable, and receive way too little attention.

Why Do Newer Fund Managers Outperform?

The data shows that emerging managers can offer significant outperformance potential versus more established funds. But why is this?

Emerging managers share the following alpha-generating characteristics:

• They have a greater incentive to outperform to attract more AUM and therefore become profitable. Quite simply, they probably work harder!

• They often run smaller funds and are therefore more nimble and agile, enabling them to concentrate on their best ideas.

• They often have ‘skin in the game’ in the form of significant company equity and/or personal investment in the fund itself.

• They often apply subject-specific expertise to niche markets.

These factors give emerging managers some major advantages over their larger counterparts and go some way towards explaining the data shown above. There are many other factors at play and choosing a new fund manager is no guarantee of outperformance – but still, this is a factor that investors should take into consideration. Choosing an emerging manager can help to tilt the odds in your favour when it comes to picking the right fund.

Then again, being an emerging manager ourselves, we would say this, wouldn’t we?

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.