BOSTON (Reuters) - In tough times, small hedge funds appear to have bested many of their bigger competitors.
As the industry digests another year of largely mediocre hedge fund returns, especially at many of the largest players, some investors are beginning to turn their sights toward smaller newcomers to deliver the kind of double-digit returns that made the industry famous.
Year-end performance numbers for 2012 are revealing a good number of industry stalwarts like Alan Howard's $34 billion Brevan Howard and David Einhorn's $8 billion Greenlight Capital fund that posted just single digit returns. John Paulson, another industry legend, had a mixed year with single digit gains in two funds, double digit gains in the Paulson Enhanced fund but double digit losses in the Advantage funds.
Overall, the average hedge fund in the $2 trillion industry gained just 6 percent, well below the 13 percent gain for the broader U.S. stock market.
With academic research finding that small funds often outperform multi-billion dollar portfolios, some investors are redoubling efforts to find the next industry star among the startups.
Analytics firm PerTrac recently reported that funds with less than $100 million in assets have outperformed much larger funds in 13 out of the last 16 years.
"We are seeing a lot more interest today in smaller funds than in the last few years," said Ted Seides who specializes in reviewing established small and select emerging managers as co-chief investment officer at Protege Partners. "Finding the right small hedge funds affords investors a wonderful opportunity to earn returns that meet return objectives and that generate risk‐adjusted returns that are among the highest available in the capital markets," he added.
For investors like Protege Partners, there was a bumper crop of top small performing firms to review, with many funds under $1 billion generating returns of 20 percent or better. But of course the caveat for investors is that many small funds are young ones with slim track records, so it can be hard to know if a manager will be the real deal or just a flash in the pan.
Some of the newer, smaller funds that posted better than average numbers last year include Aaron Cowen's $160 million Suvretta Capital Management which climbed 19.4 percent, while Jason Mudrick's $320 million Mudrick Capital, which specializes in distressed debt investing, gained 22 percent. Patrick Wolff's $113 million Grandmaster Capital gained 22 percent. Chris Hentemann's $560 million 400 Capital Management rose 34.10 percent.
These funds were founded by people with notable hedge fund pedigrees--something savvy investors look for in making their picks. Cowen, for instance, comes out of Soros Fund Management and previously worked at SAC Capital Advisors and Baupost. Mudrick came out of Contrarian Capital, a $3 billion firm which also ranked in the winner's column with a 24.4 percent gain last year. Wolff previously worked for Peter Thiel's Clarium Capital and received seed money from his former boss.
One reason smaller funds often cite for their success is that they work alone, avoiding the herd investing often seen among the biggest funds. Last year many big managers, including David Einhorn, lost millions when the stock of Apple, long a hedge fund industry darling, tumbled sharply at the end of the year. Even Daniel Loeb, whose Third Point was up 21 percent last year, acknowledged that Apple was one his top five losers during the fourth quarter.
Similarly smaller managers say they play in smaller ponds where experts expect to see big gains in 2013. Maglan's David Tawil, a former bankruptcy lawyer, said many big funds don't eye the positions he likes. "They have bigger fish to fry and so a lot of positions have become orphans and that benefits us."
Some other star performers with less than $1 billion in assets include Jacob Gottlieb's Visium Global Fund which gained 19.50 percent, Tim Griffith's Rockwood Investment Partners which climbed 33 percent and David Tawil and Steven Azarbad's Maglan Capital which rose 41 percent.
These types of highflying returns are likely to appeal to a segment of investors who may be trying to make themselves more appealing to their own clients with big numbers, analyst said.
"In the high net worth world it is all about bragging rights," said Peter Rup, chief investment officer at Artemis Wealth Advisors, about those investors who may now be dipping into small funds that boast eye-popping returns.
For example, George Fox's Titan Advisors has told investors it will concentrate more on smaller managers as it worries how the giants will fare going forward.
"We know from our long industry experience that for a variety of reasons, sometimes successful managers struggle to maintain attractive returns with larger amounts of capital," Fox wrote in a client letter in December 2011. Fox has pulled money out of Brevan Howard and Pershing Square and most recently told investors that he would be exiting Steve Cohen's SAC Capital Advisors as an insider investigation heats up there.
But investors and analysts alike caution that despite fresh interest in small funds, they won't unseat the bigger funds in pension fund portfolios any time soon.
The reason many pension funds like big funds like Viking Global Investors, York Capital or Och-Ziff Capital Management OZM.N> is their ability to perform with consistency over the years even if it comes at the expense of stellar returns.
Pension funds use hedge funds to "participate somewhat on the upside but also to reduce volatility and protect capital on the downside," said Stewart Massey, chief investment officer at Massey Quick which invests with hedge funds for individuals and institutions.
So for the moment, newcomers will likely have to keep working on their track record before attracting floods of capital from the industry's most desired and pickiest investors. "It will take a one, three, and five (year) track record and $250 million in assets to be taken seriously by the institutional world and its consultants," Artemis' Rup said.
Reporting By Svea Herbst-Bayliss; editing by Andrew Hay