Bloomberg News

Small Hedge Funds Draw Investments as Bigger Rivals Stumble

February 28, 2012

(Adds comment from Paulson letter in 22nd paragraph.)

Feb. 17 (Bloomberg) -- Richard Maraviglia spent January flying to Zurich, New York, Chicago and Miami to raise $250 million for his hedge fund.

Maraviglia, who now oversees about $610 million for Carlson Capital LP from London, raised the money because the almost 40 percent gain he posted last year made him a rarity: a hedge-fund manager who made money trading stocks. Hedge funds were down an average 5 percent in 2011 and those focused on equities fared even worse, losing 8.3 percent, Hedge Fund Research Inc. says.

Though the largest hedge funds continue to attract the bulk of the industry’s incoming money given their perceived lower risk, Maraviglia has outperformed better-known rivals including Paulson & Co., which manages $23 billion, and Lansdowne Partners Ltd., with $12.5 billion, which made big bets on stocks in 2011 and had their worst years ever. The 42-year-old veteran of Steve Cohen’s SAC Capital Advisors LLC says small size made him nimble as stocks gyrated and enabled his individual bets to make more difference to the fund’s total returns.

“Larger hedge funds have been victims of their size and the volatile markets in general,” said Andrew Lee, a New York- based adviser at JPMorgan Chase & Co.’s wealth-management unit, which helps clients find emerging managers. “Smaller funds are able to react quickly and so are better positioned.”

A January report published by Barclays found that about two-thirds of hedge fund clients plan to increase investments this year in firms managing less than $1 billion.

Overcrowded Trades

“It makes a lot of sense to invest in the speedboats over the oil tankers,” said Ben Funk, head of research at London- based Liongate Capital Management LLP, which has more than $3 billion allocated to various hedge funds.

Maraviglia, who manages Dallas-based Carlson Capital’s Black Diamond Thematic Fund, told investors during his travels last month that he started reducing bullish stock wagers in the first half of 2011, correctly betting that policy makers in China would take steps to curb inflation and the U.S. Federal Reserve would end its program of buying $600 billion of Treasuries. After a flat second quarter, the MSCI World Index lost 17 percent in the third quarter.

He then bought equities when other investors sold positions en masse in September, which made it easier for him to find stocks whose performance was no longer correlated to broader markets due to overcrowded trading. Black Diamond Thematic, which Maraviglia founded with former SAC Capital senior analyst Matthew Barkoff, gained about 4 percent in January.

Allocation Dilemma

“If you want strong outperformance, a smaller fund has a better chance of producing that,” said Maraviglia, who plans to close his hedge fund to new money after receiving commitments from investors for the $250 million. “How big an allocation can a big fund make to a great trading idea for it to make much of a difference in their total portfolio?”

Like Maraviglia, LMR Partners LLP benefited from being nimble. Its $750 million LMR Fund gained 38.7 percent last year after rising 30.4 percent in 2010, according to investors. The firm takes positions in currencies, bonds, stocks and commodities for time horizons as short as a day, based on economic data and price discrepancies spotted by computers.

Former UBS AG traders Benjamin Levine and Stefan Renold and ex-Goldman Sachs Group Inc. trader Andrew Manuel kept size in mind when they started London-based LMR in 2010. They stopped taking money in April as assets grew to about $600 million, with the majority of the firm’s capital coming from Donald Sussman’s Paloma Partners LLC, said two people familiar with the matter. They declined to be identified because the firm is private.

OVS Switches Tactics

When LMR decided in November to accept more money at a higher performance fee of 30 percent, rather than the 20 percent they had been charging, clients sought to invest $300 million, the people said. LMR accepted about $150 million and closed the fund. It’s now raising assets for a new hedge fund.

OVS Capital Management LLP has increased its assets to more than $300 million from $18 million in January 2011 after making profitable trades from a strategy that proved challenging for hedge funds last year: betting on European companies they thought were likely to be taken over.

When mergers dried up amid uncertainty over Europe’s debt crisis, OVS switched tack into so-called relative-value trades that try to benefit from small price differences in related securities, according to a Jan. 12 note sent to clients. OVS plans to close its hedge fund to new investors in April.

Smallest Funds

London-based OVS, led by ex-HBK Investments LP trader Sam Morland, rose 7.8 percent last year and gained about 2 percent in January. Other so-called event-driven hedge funds with a European focus fell 5.4 percent in 2011, according to Singapore- based data firm Eurekahedge Pte.

Executives at LMR and OVS declined to comment.

Data from Barclays Capital shows that modestly sized hedge funds are both the industry’s best and worst performers. Worldwide, funds with less than $100 million of assets reaped an annualized average gain of 10.1 percent from 2001 through 2010, according to an April study published by the London-based securities firm. Firms managing between $100 million and $500 million returned 8.3 percent a year over the same period, and those with more than $500 million of assets returned 8 percent.

The outperformance was more pronounced when Barclays limited its study to firms with the best returns. The top quartile of small hedge funds generated annual average returns of 99 percent, while mid-sized firms rose 71 percent and the biggest funds gained 60 percent.

Greater Downside

The opposite also proved true, with the worst-performing small funds losing 39 percent a year between 2001 and 2010. Big hedge-fund laggards had average losses of 27.6 percent over the same time period.

“Investors should choose their small funds wisely,” Barclays analysts wrote in the report. “If they select winners, they have the potential to win big, but if they falter, the downside is comparatively greater than larger funds.”

Volatility in financial stocks hurt large managers like Paulson and Lansdowne last year. John Paulson, 56, who made billions of dollars betting against the U.S. housing market in 2007, incurred losses of 51 percent last year in one of his firm’s biggest hedge funds on investments in Citigroup Inc. and Bank of America Corp. Lansdowne, a stock-trading firm based in London, was down 20 percent in its biggest fund after making bullish wagers on banks including Lloyds Banking Group Plc.

Big Funds Rebound

Paulson addressed his critics in a letter sent to clients this month, saying “some people have suggested that our negative performance in 2011 was due to our size.” The firm “outperformed the markets and our peers” in 2008, 2009 and 2010, all years when the hedge fund was bigger than it is now, according to the letter, which was obtained by Bloomberg.

To be sure, both Paulson and Lansdowne have done well in 2012 as falling U.S. unemployment and the European Central Bank’s help for lenders pushed the MSCI World Index to its best start to the year since 1994. Paulson’s Advantage Plus Fund rose 5 percent in January and Lansdowne’s U.K. Equity Fund gained 5.6 percent, the most since May 2009, according to Bloomberg data. Hedge funds broadly rose 2.6 percent last month, the industry’s best January since 2006, according to Hedge Fund Research.

Paulson has reservations about the bull market, telling clients in his letter that Greece may default by the end of March and trigger the breakup of the euro and a global recession. His skepticism is matched by Liongate Capital’s Funk, who cited the dangers of debt woes worsening in Portugal, Italy and Spain and U.S. joblessness rising.

‘Bumpy Year’

Liongate says that even if larger funds correctly predict a downturn, they may be too big to easily change course and protect their returns.

“There are lots of reasons why it will be a bumpy, highly correlated year” that benefits smaller managers, Funk said.

The Chicago Board Options Exchange Volatility Index, which rises when investors predict price swings for stocks will increase, jumped to a two-year high of 48 in August after Standard & Poor’s cut the U.S. government’s credit rating. The gauge has since declined to 21 as of Feb. 15.

Hedge funds overseeing more than $5 billion drew 70 percent of net capital raised by the industry in 2011, according to Chicago-based Hedge Fund Research. Though that’s down from 80 percent in 2010, the largest firms are still the most able to absorb the large checks written by clients such as pension funds and sovereign-wealth funds.

“As institutions increase their allocation to hedge funds, the focus on established managers with longer track records, significant assets under management and robust infrastructure will continue,” said William Smith, Morgan Stanley’s European head of hedge fund capital introductions.

Corner Cafe, Starbucks

Barclays analysts say they’re skeptical that investors will follow through on intentions to allocate more to small managers. The bank’s poll surveyed 165 hedge-fund clients who had about $500 billion invested during last year’s third quarter.

“It’s more an indicator of desire for size diversification, rather than something that is necessarily going to translate into action,” said Anurag Bhardwaj, Barclays Capital’s head of strategic consulting. “If there is extreme market volatility and you don’t know what is going to happen next, your instinctive reaction is to stick with the tried and tested.”

Another risk of investing in hedge funds with less than $1 billion of assets is that they are more reliant on incentive fees generated from good performance to run their business and pay staff, Bhardwaj said. A stretch of losing years can force a small firm to shut down because it can’t retain talent, he said.

Maraviglia concedes that’s true.

“If you take a hit or something goes wrong, there’s a bigger risk of blowing up,” he said. “It’s more likely for a small coffee shop down the road to go bust than Starbucks.”

--With assistance from Saijel Kishan in New York. Editors: Keith Campbell, Edward Evans.

To contact the reporter responsible for this story: Jesse Westbrook in London at jwestbrook1@bloomberg.net

To contact the editor responsible for the story: Edward Evans at eevans3@bloomberg.net


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