As hedge fund seeders we prefer specialist managers for various reasons. Some of these are investment driven (top tier specialist managers are more likely to need a seed deal, and thus as a seeder we are less likely to suffer from adverse selection), some are operational (covering more ground requires larger teams which need larger seed tickets to break even) some of these are commercial (specialist managers are more differentiated and find it easier to raise day 1 or early investor capital). Investment drivers are the focus of this note. Do specialist managers outperform generalist managers? This is a difficult question to definitively answer given there is no universally agreed-upon definition of specialists. Stable’s definition of specialist managers is those who focus on a more clearly defined investment sector or universe; often with capacity constraints of ~$1-2B. A few examples of these are: small/midcap L/S equity, sector or country-focused L/S equity, EM macro, special situations/distressed credit, commodities, volatility arbitrage and niche systematic.
In private equity, there is a tendency for sector-focused funds to outperform generalist funds, as outlined in a Cambridge Associates report, which found significantly higher MOIC’s and IRR’s amongst funds with a heavier sector focus 1. The conclusion was that specialist outperformance comes from a deeper, more intimate knowledge of a certain industry which generalists cannot replicate across multiple areas. It is commonly argued that this advantage carries over to hedge funds as well 2. A Novus paper found that there was a trend for more sector specialism amongst equity managers, and highlighted that specialists within certain sectors (for example, healthcare, TMT, consumer or information technology) tended to have a greater potential for alpha given the greater levels of specific knowledge of the managers as well as opportunity dispersion within these particular sectors 3. Research of various hedge fund data bases has not yielded a ubiquitous means of comparing specialist managers with a more generalist approach – although the signs do point towards the relative outperformance of specialist strategies when compared to mainstream generalists. According to Eurekahedge data, from October 31, 2007 through October 31, 2017, Emerging Market Macro managers outperformed Global Macro managers by 21% in aggregate, over the period.
Similarly, in equity L/S, the HFRI Equity Hedge: Sector – Technology/Healthcare Index outperformed the HFRI (Global) Equity Hedge Index by 45% over a similar period
In terms of capacity constraints, multi-billion funds have generally been shown to underperform due to their size, as limited market volumes can affect trading performance and potentially lead to style drift. Return volatility often dwindles and managers have been arguably known to become comfortable with significant management fee income rather than focus on generating performance. One study analyzed returns from 3,177 funds and found that smaller, more nimble managers outperformed larger managers both before and after the 2008 financial crisis by an average of 2.75% per annum 4. Stable’s focus on capacity-constrained specialist strategies that can rarely be run at above $2B helps to mitigate this potential size issue. Specialist managers are able to focus on underfollowed, more dispersed opportunities to generate alpha and are incited to drive fund performance to earn their compensation, rather than rely on management fees 5. Using Stable’s investment team’s own experience in day-1 investments across all types of managers, one can see a clear trend of specialist outperformance: specialist managers outperform by over 6% annualised from this subset. Of course, we like to think that this is due to the fact that we excel at picking specialists, but in large part this is self-fulfilling by focusing on specialist only.
As an organisation, Stable has a preference for process-driven, bottom-up hedge fund managers, as it is felt that this type of manager is easier to underwrite and predict the future performance of than managers with a more of top-down approach. This preference likely biases Stable to more specialist managers, who tend to dig deeper into the fundamentals of an opportunity to deliver true alpha – a view supported by Stable’s investment team’s experience.
Stable’s philosophy on specialist managers can be seen in practice when our immediate manager pipeline is explored. Within the equity L/S space, all of the top candidates are focused on the small and mid-cap sectors. Stable’s view is that specialists in this universe are best placed to exploit inefficiencies that more likely to persist in less widely researched or held companies. Adding another level of specialization, within small and mid-cap equity L/S, there is one manager with a specific geographic focus and one with a particularly strong skillset on the short side.
Stable’s view is not dogmatic, remaining mindful that there are generalist managers who have outperformed their peers consistently and deliver top quartile performance. For generalists to be successful, however, they usually need large investment teams to be able to cover a wide investment universe in sufficient detail. This is difficult for a start-up manager with a limited budget and a desire to keep breakeven levels low. Similarly, most successful generalist managers have seen efficient teamwork structures, processes and cultures evolve so that large teams can work together optimally without yield loss or a move to a less nimble, innovative and streamlined investment process. Bridgewater, with its unique culture and structure of radical truth and transparency, is a prime example of this. Such evolution takes time and money, and so again is more difficult for a start-up manager to get right in the early stages of their development.
One final thought is how specialist managers fit together in an investor’s portfolio. Too often specialist managers are relegated to a ‘satellite’ portfolio, with core holdings consisting of more generalist, ‘mainstream’ managers and smaller investments in specialist managers as ‘satellites’ to the core. A group of generalist managers with wide investment universes, however (even if they have different approaches), may well end up investing in similar themes and areas, potentially magnifying concentration risk within an allocator’s portfolio. A portfolio of specialists helps to mitigate this, with investors being able to carefully add ‘building blocks’ of specialists with different areas of focus to create a well-diversified core portfolio, with more control and reduced concentration risk. This is Stable’s approach as it launches its second portfolio of backed managers: selecting the best specialist managers across different strategies to offer our LPs exposure to a diversified portfolio of emerging managers who are truly ‘masters’ of their fields