Bigger isn't always better when it comes to investing

Investors who exclude smaller, early stage funds from their portfolios, opting instead for only larger funds with a proven track record could be missing out on the opportunity for significant outperformance that these funds can offer.

According to Thomas Schlebusch, Chief Investment Officer at Blue Ink Investments, while this is true for funds across the asset management spectrum, it is particularly relevant when it comes to hedge funds. This was recently demonstrated by the Blue Ink-ubator Diversified Fund – which invests in early stage hedge fund managers – being awarded the Best Fund of Hedge Funds at the 2010 HedgeNews Africa Awards.

According to Schlebusch, many investors often make the mistake of shunning early stage funds on the basis that they don’t want to invest in a fund without a proven track record. “While an early stage fund itself might not have a proven track record, it is more important to ascertain whether the manager of such a fund does.”

“The fund manager will most likely have a history in managing other funds or in managing a proprietary book at a bank. The success, or not, in his previous positions should provide some guidance as to his ability.”

Schlebusch says there are a number of advantages to investing with early stage funds, size being one of the biggest factors. “Early stage funds are by their nature, generally small, and the manager is therefore quite agile, with the capability to harvest many smaller opportunities versus their larger counterparts.”

“The size of assets under management can prove to be a common constraint, both for hedge funds and for traditional asset managers. Once the number of investors and assets grows past a certain optimum level, the investible universe available to the fund diminishes rapidly, particularly in a country like South Africa, which has a relatively small market.

According to a 2004 paper published in The American Economic Review, a large asset base can erode the performance of a fund. “Whereas a small fund can easily put all of its money in its best ideas, a lack of liquidity forces a large fund to have to invest in its not-so-good ideas and take larger positions per stock than is optimal, thereby eroding performance.”

Schlebusch adds that while the decisions being taken by the fund manager may not differ to those of smaller funds, the level of complexity involved in making new investments increases significantly.”

He says investors can also benefit financially from investing in early stage funds, as in many cases these managers are ’hungry‘ to grow their asset base. “These fund managers are often willing to negotiate on fees, which can make a significant difference to your net returns.”

Schlebusch says the other important point to note when deciding where to place your money is the strategy of the fund. “Very often, new early stage fund managers are those who have identified neglected strategies or strategies where “crowding” of specific trades by the rest of the market has not yet reduced the size of the benefits they could potentially harvest.”

He says it is important for investors to look at all the options available to them rather than one type of investment strategy. “Diversification is key to a good investment strategy and there are benefits to investing in both large and small fund managers, be they hedge funds or traditional asset managers. For example, larger, more established funds often have research support that is hard to match by smaller funds.”