Directors Najy Nasser and Henry Watkinson explore the alpha premium of emerging markets, highlighting that getting a head start benefits investors long-term.
Najy and Henry’s article was published in Alternative Fund Insight, 8 April 2025, and can be found here.
When harvesting the emerging managers’ alpha premium, getting ahead matters. Research[i] shows that fund managers often perform best when establishing a new fund: they focus more on performance, posting strong returns to attract investors.
Emerging funds can move assets faster, exploiting opportunities before potential returns diminish. This alpha premium is particularly strong where funds are led by portfolio managers with a larger hedge fund or banking background. Having previously managed large portfolios, they combine experience with agility in managing fewer assets.
Getting a head start
Certain funds of hedge funds (FHFs) have an edge in building relationships, securing capacity, access to Founder Share Classes and better fees. Smaller FHFs are better placed to exploit the alpha premium.
Investment into emerging fund managers requires experience, balancing new funds’ failure rate with their lucrative potential. FHFs should allocate time and resources to understanding how investments in emerging fund managers fit into an overall portfolio. FHFs can make allocations which move the needle both for the emerging manager and the FHF.
It is easier for smaller FHFs as emerging fund managers often need to increase their investment capacity, but cannot handle too much capital too early. Given capacity constraints, a $5bn FHF may be unable to allocate a 5% position (i.e. $250mn) to an emerging fund manager.
A smaller allocation, say $10mn, is rarely viable for larger FHFs, which rule out investing with emerging fund managers until they reach a ‘critical mass’ whereby the FHFs investment represents no more than 10% of total AUM in the hedge fund.
This critical mass continues to increase in line with industry assets, the growing regulatory burden and demand for institutional-level infrastructure. Larger FHFs usually wait until a fund manager has at least six months’ track record within their firm.
Without these constraints, smaller FHFs can harvest fund managers’ potentially strong early years.
The more capacity constrained a strategy, the bigger the advantage of a head start. Sometimes, a fund manager’s performance potential may be depleted before they cross the radar of larger FHFs. Some quantitative/systematic strategies, for example, have high Sharpe Ratios of three or above, but are more constrained.
Long-term benefits
Getting a head start benefits investors long-term. Beyond strong performance, emerging fund managers are more willing to negotiate fees.
Investing with them from day one often opens the door to Founder Share Classes, where fund managers offer some capacity at lower fee levels throughout the life of the initial investment.
Emerging fund managers can offer substantial fee-breaks that prove very worthwhile to investors over time, enhancing the alpha premium and extending its value. For example, assume a hedge fund returned 15% net of a 2% management fee and 20% performance fee: If fees are negotiated to 1% and 10%, the net investor return increases to 17.78%. Compounding over five years would equate to performance of 25.51% and over ten years by an impressive 109.15%.
Another less tangible benefit is available to early investors: Frequently, future capacity can be secured during initial negotiations, allowing the FHF first refusal on additional investment opportunities as it grows. Even where that cannot be contractually secured, fund managers naturally prefer investors with whom they have a strong relationship, especially those who showed early support. Existing investors can opportunistically add to their investments, even in closed funds as there is invariably limited rebalancing by investors, or where funds need to take in a limited amount of capital to cover costs.
The advantage of a head start therefore includes effectively securing capacity for the long-term as some emerging fund managers develop into tomorrow’s ‘blue-chip’ funds.
Harvesting the Alpha Premium of Emerging Managers
Selecting those fund managers is rarely straightforward, however.
Although nimbleness is critical to success of emerging hedge funds and the FHF investing in them, tenure is vital in recognising tomorrow’s potential blue-chip winners. At the FHF level, experience matters in identifying which funds have odds stacked in their favour making them more likely to succeed.
To remain agile, harvesting the alpha premium requires efficient, entrepreneurial, decision-making. Long-term success, however, requires a broad relationship network and an ability to select enduring talent.
To exploit the head start advantage, experience, strong relationships and an established, yet nimble investment process is essential. This requires experience of investing in emerging hedge funds through market cycles.
Combining a nimble, experienced fund manager selection process with risk-conscious, performance-hungry emerging managers can yield significant results.
[i] Hedge Fund Research 2012, Pertrac 2012
