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?” 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.

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.
- Ted Krum, senior researcher and portfolio manager with Northern Trust Global Advisors

“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, co-founder, 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.”

The Potential Benefits of Investing With Emerging Managers

Exploiting depth in negative and positive security selection

Northern Trust’s white paper, “Potential Benefits of Investing With Emerging Managers: Can Elephants Dance?” found that for the five-year period that ended Sept. 30, 2005:

• Small firms delivered dramatically better performance in down markets.
• Almost 40% of the top-quartile managers in the study managed less than $2 billion.
• Skill in manager selection was more likely to be rewarded when applied to the small firm universe.

Read Northern Trust’s complete white paper here.

Source: Nelson's Marketplace, Northern Trust.

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