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Spotting value in smaller funds: how can private investors break away from the mainstream?

16 October 2015

For most private investors, investing in funds usually means only one thing: traditional equity funds run by large fund managers. While this approach is often seen as the “safe” option, it’s also generally the only option. But as investment professionals know, too much of a “good thing” can be a risky strategy. The private client investment industry should be asking itself: are private investors’ interests really being well served by always sticking so closely to the mainstream?

“Portfolio diversification” may be a core tenet of investment strategy but in reality it can be hard to achieve. There are plenty of sophisticated investors who want to deploy a more balanced approach by including smaller, uncorrelated, niche or emerging asset funds as part of a portfolio that is truly diversified: but there they hit a brick wall. There’s no way to access them. They can’t do it alone, and they are not generally available through most investment platforms.

The tendency amongst advisers to recommend larger, well established mainstream funds rather than smaller ones has very little to do with performance. After all, big is not necessarily better. The idea of a correlation between size and success is tenuous at best. For example, recent research from Cass Business School (commissioned by Gatemore Capital Management) has shown that smaller hedge funds outperform large ones – even in times of economic turbulence.

There are several reasons why smaller, non-mainstream funds can offer attractive returns potential. For a start their size may mean they are more tightly focussed on specific strategies, more agile at spotting good opportunities, with more hands-on expertise at senior level and more flexibility to take a longer term view.

They may be targeting niche markets or emerging asset opportunities, and therefore have the freedom not to follow the herd as well as the ability to spot value that other mainstream managers may not see.

Or they may provide investors with opportunities to invest in assets which are totally uncorrelated to other asset classes they are likely to hold in their portfolios – notably stockmarkets - providing a good hedge against shocks elsewhere in the financial system. And as we’ve seen in recent years, that kind of defensive tactic could pay off when other mainstream assets are tanking.

Some may offer a combination of all of the above.

So why aren’t more advisers offering them to clients? One reason is big brand security: it’s true that “no one ever got fired for buying IBM”. Well-known, well-established names provide a sense of confidence, even if performance is not top quartile.

Another reason is that advisers are not required to exercise anywhere near as much in the way of judgement or intensive analysis when recommending a large fund manager who has been around for some time. Smaller, more esoteric funds simply tend to go unnoticed.

Since even small funds don’t generally deal direct with individual investors – even highly sophisticated ones - what are investors intrigued by the prospect of exciting opportunities which fly under the radar of mainstream investment platforms, wealth managers, private banks and IFAs to do?

Clearly, a radical new approach is required. After all, institutional investors are recognising the value of small or niche, yet highly-performing, funds that are offering innovative strategies ranging from private equity liquidity funding, mezzanine debt, or commercial litigation. Why should experienced private investors with the right risk appetite and profile be locked out?

The answer is for private investors to become institutional investors themselves. That might sound like a contradiction in terms, but specialist investment businesses now exist which enable them to do just that, aggregating their investment power but acting as a single point of contact: effectively acting as an institution on their behalf. This is not a fund of funds model – the layers of fees associated with that approach often kills returns. This is about direct access to top performing funds who have no desire to become the next BlackRock or Invesco and therefore keep a low profile.

In order to be successful in choosing the right funds to place capital with, a similar approach is needed to sourcing, negotiating and managing investment opportunities to that of a pension fund or sovereign wealth fund. Private clients need to be represented by experienced and proactive investment professionals who have the expertise and industry connections to spot value as well as the reputation and track record to be taken seriously as an institutional player.

This is still a highly niche area in itself, but one that is growing to fill a clear gap in the market. Our experience is that there are many experienced, sophisticated private investors out there who have a higher tolerance to risk than your average retail investor and who are frustrated that their requirements are not being served. Small, uncorrelated non-mainstream funds should all have a place in a well-rounded investment portfolio – it’s time the industry started to help private investors achieve true diversification.

Contact Russell O'Connor
07760 282 586 or Email