EMERGING MANAGERS
GAIN GROUND
Smaller, newer and minority-owned
asset management firms are garnering attention with institutional investors.
Institutional investors often put constraints on their search for asset managers. But in limiting their
pool of managers, are they also imposing constraints on potential investment returns? Often overlooked are emerging managers
— typically firms with less than $2 billion under management or with a track record of less than five years. Emerging
managers also are often minority- or women-owned firms. Frequently they are too new to register on financial databases. In
addition, these managers often face minimum size requirement hurdles imposed by large plan sponsor searches.
“Consultant research resources are largely spent covering managers that are applicable
to the greatest number of investors,” explains Larry Jones, practice leader for Northern Trust’s emerging and
minority programs. But investors passing on smaller firms might be forgoing investment potential as well.
Research from Northern Trust shows that, over time, smaller firms have achieved a performance
edge over larger firms. Drawing from Nelson’s Marketplace database, which encompassed 531 active core U.S. equity products
managed by 287 firms, managers were divided into five groups based on size. The full analysis of the research, which examines
data for the five-year period that ended Sept. 30, 2005, is presented in the Northern Trust white paper “Potential Benefits
of Investing With Emerging Managers: Can Elephants Dance?” The paper can be found on the Point of View Web site
at northerntrust.com/pointofview. One key finding was that roughly 40% of the managers in the top-performing quartile were
firms with less than $2 billion under management.
“Plan sponsors unwittingly exclude themselves from investing with managers who
have produced some of the best returns out there and represent some of the best talent in the marketplace,” notes Northern
Trust’s Ted Krum, author of the white paper. “Our research found that for the five-year period studied, smaller
firms outperformed larger investment firms at the median as well as at the top- and bottom-quartile levels. Performance was
consistent across all major style groups. Pension plans and other institutional investors might want to examine their investment
policies and be more willing to look at these smaller firms.”
To test performance in various market conditions, Krum conducted his study four times
since 1993. Every time, the results were largely the same: As a group, small managers demonstrated stronger performance than
the other groups analyzed.
Hiring of Smaller
Firms on the Rise
Plan sponsors are increasingly
recognizing the potential benefits of incorporating up-and-coming asset management firms in their roster of money managers.
To date, the majority of the interest has been in U.S. equity, but investors are expressing a growing interest in other asset
classes.
“The groundswell of interest in investing with emerging managers can be attributed
to the various objectives of plan sponsors,” says Jennifer Tretheway, director for manager of manager services at Northern
Trust. Tretheway notes that today there is an equal amount of interest in emerging managers from public and corporate pension
plans. She explains, “Many plan sponsors are looking for a more diverse group of investment managers. Sometimes that
comes from having a broad employee base or from having a diverse group of customers or constituents. People in key positions
who are personally passionate about the topic often promote the practice.”
Other factors are legislative inducements or pressure from suppliers. For instance, suppliers
to the auto industry may be encouraged to use minority firms, Tretheway notes. Some companies have broader development guidelines
that require allocating a certain percentage of purchasing to minority firms.
The Pension Consulting Alliance based in Portland, Ore., recently published a report
entitled “Review of Developing Managers and Developing Managers Programs.” The report states, “Given the
demographics of the U.S. population (51% female and 25% nonwhite), which are reflected in constituencies of many public plans,
it is only appropriate that these individuals be given an opportunity to manage fund assets. Using developing management firms
provides an opportunity to broaden manager diversification while achieving competitive returns.”
Small Firms, Greater
Agility
As institutional investors
continue to search for alpha, they should consider the historical findings that emerging managers have delivered strong returns.
“Ted Krum’s research provides empirical evidence that it is within the fiduciary duty of plan sponsors to pursue
these types of asset managers because of the premium performance that may be delivered,” Jones says.
Krum’s research found that as a group, smaller money management firms didn’t
suffer the degree of volatility exhibited by the groups of larger firms. “In up-market periods, small firms outperformed
just as often as other firms, but by a smaller margin. In down-market periods, however, the small manager composite outperformed
in every case, and by the widest margin of any group,” Krum notes.
“When a piece of negative news — a disappointing earnings report, for example
— surfaces, emerging managers can be more agile and more quickly execute a trade,” Jones explains. “At large
firms, you often see management hierarchies and investment committees where all purchase and sale recommendations must be
vetted before they can be executed. We have seen that it is typically easier to protect assets in a falling environment at
smaller firms because there’s less bureaucracy clogging up the investment process.”
In fact, frustration with bureaucracy sometimes drives enterprising investment talent
to quit Wall Street and launch their own firms. “By starting out on our own, we felt we could better tailor all of our
resources toward our investment process without having to compete for those resources with other corporate objectives,”
explains Quinn R. Stills, cofounder, chairman and CEO of Palisades Investment Partners, a Santa Monica, Calif.-based firm
with $800 million under management. Stills helped launch the firm in 2003 after managing funds at Dreyfus and The Boston Company.
“At the larger firms we had to submit budgets and get approvals and so forth. Here, we’re able to focus on a single
task — generating returns for our clients,” he adds.
Maintaining a Singular
Focus
This steadfast focus
is a running theme among emerging managers such as Palisades. “With smaller firms, there’s a tremendous focus
on managing the investment portfolio,” Tretheway says. “People are truly motivated at these firms and frequently
have a higher level of employee ownership. They’re also not as diverted by other activities. Many of these managers
are single-product firms and they often work as a tight team.”
Smaller firms’ performance illustrates a key point: Although the firms often lack
lengthy track records, the managers themselves aren’t necessarily newcomers. “Emerging organizations generally
have two or three decision-makers who are very experienced,” Jones says. “Although the tenure of the firm might
be short, the managers might have 10 or 20 years of experience.”
Overcoming Individual
Manager Risks
Nevertheless, investing
with emerging firms can carry considerable risk. “Individually, small firms tend to have
less predictable performance,” Jones notes. Consequently, investors face an increased
risk if they hire only a few small firms. Investing in these firms also can be time-consuming for a plan’s investment
staff as it requires on-site visits and ongoing calls with each manager they hire. When working with multiple managers, plan
sponsors often find it challenging to maintain an adequate level of due diligence for the emerging managers. If the relationship
sours, terminating a manager also could create unwanted publicity for the plan sponsor.
These risks tended to be reduced when examined in groups, as in a diversified multi-manager
program, Northern Trust’s research found. “Typically, multi-manager programs pool a variety of emerging money
managers,” Tretheway explains. “A program evaluates and monitors up-and-coming managers and looks to combine them
in such a way that investors can get the benefit of the synergies they generate. The goal is to generate greater performance
potential at a lower level of volatility.”
Quantitative tools can help determine the expected optimal combination of managers and
how those managers are weighted within the program. Customized solutions can be created depending upon the aims of the program
and the skills of the managers. Often the program managers have evaluated hundreds or thousands of emerging investment firms
on qualitative and quantitative standards, such as portfolio data, staff qualifications and regulatory compliance.
Multi-manager programs can help nurture small companies and improve weak areas within
their operations. For the emerging managers, that can mean help in executing trades, hiring employees, marketing client service
or navigating compliance requirements. And if an emerging firm doesn’t ultimately live up to its potential, it can be
removed from the multi-manager program without casting harsh light on the plan sponsor using the program.
Emerging manager programs ultimately can introduce institutional investors to a pool
of untapped investment management talent. “These programs offer a way to get to know the firms and perhaps consider
them for inclusion at the full-funding level,” Tretheway says. “They give investors an opportunity to look at
talent, develop it and grow it.” ❖
