PSolve believes that newer strategies often offer a better
risk-and-return profile than more established approaches. PSolve therefore aims
to identify funds that are either implementing completely new stratagems or
funds adopting novel variations of old ones. The company seeks funds that
typically have less than $400 million under management and have a policy of
capping the amount of capital they will accept. “The managers are typically
capping themselves early, so they’re not trying to put $4 billion to work in the
U.S. real estate space, for example,” Appavoo says.Appavoo argues that from
a risk perspective, small, untested funds can actually be a safer bet than their
larger counterparts that already have a trading history. “If you look at the
big, huge hedge funds out there playing the mainstream—like people that are
playing the G7 government bond markets—they tend to be leveraging those
arbitrage plays up to the hilt, which means when it goes wrong, it goes wrong
quite badly,” he notes. Niche players often do not have to rely so much on
leverage to meet the returns targets thereby taking less risk than the bigger
funds, he argues.
Warning Label
But niche hedge funds are not without their dangers. Even if
they do not rely principally on leverage, these funds may well be operating in
very volatile markets, or they may be making very illiquid investments. Baron
Advisors’ Fattouh, for example, runs a shareholder activism fund. This fund
takes a significant stake in a business—frequently 5 to 10 percent, which will
often make it the dominant shareholder—with a view to using its power to
increase returns to shareholders, he explains. “It involves challenging
management to do what is in the best interests of the shareholders, which might
be to sell certain assets, sell the entire business, repurchase shares or
dividend out cash.” This sort of corporate restructuring play can take a long
time to pay off, so when considering it from a liquidity standpoint, it may
resemble a private equity fund rather than a hedge fund. “You derive your upside
from the inefficiencies related to the market’s imperfect interpretation of
underlying businesses, rather than short-term pricing discrepancies,” Fattouh
explains. Other risks also come into play. The potential that a manager will
commit fraud, for example, will generally be higher with niche funds. “Small
funds do have more organizational risk, and as a private investor, you would
have more comfort having due diligence done by an advisor or a fund of funds,”
Fattouh observes. Appavoo adds, “We make sure that they’ve got a full
operational set up, a complete back office, independent administrators and
independent custodians doing the pricing. We make sure that, to the extent
possible, the funds have liquidity, that they can match the liquidity they are
offering us with the liquidity of the underlyings.” Also, since these funds
are by nature small, it is often difficult to find and access them. PSolve uses
a combination of prime broker contacts, independent capital introduction firms
and its own industry connections. Wealthy investors who do not have access to
such a network can turn to a fund-of-funds manager or advisor who does. By
deliberately not running with the herd, niche hedge funds may offer compelling
investment opportunities. However, they do not come with the implicit
operational safety net usually offered by their larger peers, which makes
careful selection of funds and ongoing due diligence especially important.
John Ferry is a senior correspondent for Worth.
Photograph by MediaBakery/Corbis.
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 Small is Beautiful
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