NEW YORK (TheStreet) -- The financial crisis clobbered hedge funds. Many suffered big losses in 2008, and hundreds went out of business. That has left investors wary about trying small funds with short track records. Seeking security, many institutions and individual investors have been sticking with large hedge funds that delivered competitive returns during the downturn.
According to data provider Preqin, 66% of fund investors would not consider managers with track records of less than three years. Many institutions will only invest in hedge funds with more than $300 million in assets. "It is getting harder and harder for smaller funds to survive," says Nadia Papagiannis, alternative investment strategist for Morningstar.
However, the flight to blue-chip funds could lead to lower returns. According to a recent study by hedge fund analyst PerTrac, small funds tend to outdo large ones, and young funds surpass older portfolios. Examining returns from 1996 through 2010, PerTrac compared three groups of hedge funds: Emerging funds that were less than two years old, mid-age funds that were two to four years old, and veteran funds with track records of more than four years. During the period, emerging funds returned 16.2% annually, while the mid-age group returned 12.2%, and the veterans only delivered 10.9%. Small funds with less than $100 million in assets outdid larger funds by a wide margin.
Some analysts argue that small funds will continue outperforming because they enjoy key advantages. While small funds can trade nimbly, giant portfolios can be hard to maneuver, says Danielle Silva, a research analyst for Brighton House Associates, a consultant that helps investors select hedge funds.
"Small funds can react quickly and shift their positions in response to concerns about the European debt crisis or other issues," she says.
Small funds may get higher returns because the fee structure provides them an incentive to take more risks, says Nadia Papagiannis of Morningstar. Under the traditional fee structure, hedge funds charge an annual management fee of 2% and a performance fee that equals 20% of all profits. Because small portfolios only generate skimpy management fees, managers of emerging funds must swing for the fences to achieve big trading profits. In contrast, big funds can rake in huge profits simply by maintaining their assets and collecting the 2% annual management fee.
"The more money you have, the more conservative you become in your management style," says Papagiannis.
Recognizing that small funds may have an advantage, some institutions have made special efforts to invest a portion of their assets with emerging managers. The California Public Employees' Retirement System has invested $700 million with emerging managers, while the Illinois Teachers' Retirement System has begun a program to invest $500 million.
Most emerging managers serve institutions, but retail investors can participate by trying some mutual funds that rely on managers of small or young hedge funds.
Hatteras Alpha Hedged Strategies
, which has $380 million in assets, hires 24 outside managers, including managers of emerging funds. While they all have day jobs running hedge funds, the managers sign up to oversee some separate money for Hatteras.
Working for Hatteras, the managers employ the same strategies that they use in the hedge funds. Each manager follows a different strategy. Some trade bonds, while others invest in stocks.
The Hatteras fund's goal is to deliver consistent returns that are not correlated with movements in stocks and bonds. Most often the fund has succeeded. During the past three years, Hatteras has returned 7.8% annually, outdoing 89% of peers in Lipper's category of absolute return.
Though many of them run emerging funds, the managers of the Hatteras fund are not novices. Some have set up their own small shops after working for large hedge funds. Others are still employees of big companies, but they have been assigned the task of starting new funds.
The Hatteras mutual fund offers some clear advantages over traditional hedge funds. The initial minimum investment is as low as $1,000. In contrast, hedge funds typically require initial minimums of $250,000 or more. As a mutual fund, the Hatteras fund allows daily deposits and withdrawals. That is very different than typical hedge funds, which can lock in investors for three months or longer.
The Hatteras annual expense ratio is 2.99%. "In comparison to other mutual funds, our expense ratio may seem expensive, but it is very low compared to hedge funds," says Michael Hennen, who oversees the Hatteras fund.
Hennen says that emerging managers suit his approach. Because the managers tend to be hungry, they are willing to accept lower fees in return for gaining access to the huge pool of retail mutual fund investors.
A new mutual fund that relies on hedge fund managers is
Orinda Multi-Manager Hedged Equity
. While it doesn't select emerging managers, Orinda favors managers with small portfolios. "We prefer experienced managers who can be nimble," says Larry Epstein, chief investment officer of Orinda Asset Management.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.