Institutional Consultant: “Why I Rarely Invest in Emerging Managers”

Had breakfast with the CIO of a sophisticated consultant recently. Unlike many of his peers - he has significant buy-side experience having traded a variety of asset classes prior to co-founding a billion dollar hedge fund. His current firm advises institutional clients representing over $100 billion dollars in assets

When the conversation turned to investing in emerging managers, he simply smiled and shook his head.

Of course there are a plenty of reasons to be cautious about investing in emerging managers, but I pressed him anyway. We discussed all of the studies highlighting alpha generation, an emerging manager’s ability to be more nimble, opportunities to take risk in niche situations due to their size and so on.

No reaction.

Finally, I said with a hint of exasperation, “For goodness sakes, weren’t you one of those guys once yourself??”

The devil that you know…

So what’s his issue? It boils down to risk / reward. How much incremental return is required to justify accepting the risk of investing in an unknown quantity like an emerging manager? He didn’t have a specific answer but I definitely know that it is bigger than a breadbox.

Oh, yeah? Prove it!

The first thing worth noting was that the word “emerging” never actually crossed his lips. He preferred the term “unproven.” His comment…“No matter what you may hear, institutions are managing sleep at night money. Sure, there is a place for unproven managers, but at the end of the day, the adage holds true - return of capital always trumps return on capital.”

He summarized in this way: “Losing money due to a hiccup in performance is inevitable. Losing money for practically any other reason is inexcusable.”

You will never eliminate business risk – but you can manage it by investing with managers that have proven experience running a fund. Learning to run a business takes time and requires practice. “Even guys like Babe Ruth and A-Rod were sent back down to the minors early in their careers.”

Wait – I’m already in a relationship

“Returns do matter but justifying all of that brain damage comes down to a lot more than just a few extra basis points.

First test when a new fund gets put in front of me is, how do they compare to the funds we already own that do the same strategy? The managers in our portfolio have been doing it exceptionally well for a long time. It would take a serious bump in performance to consider displacing them.”

Having said all of that – it wasn’t that long ago when he was that guy. Despite his talk, I got the sense there is still a soft spot in there somewhere.

By JD David