“Overcrowding is taking place, and in many cases the only way managers are deriving returns at all is through using significant leverage, either at the hedge fund or the fund-of-funds level, which isn’t really the premise of how a hedge fund was supposed to deliver its returns to begin with,” says Ahmed Fattouh, a partner with investment and advisory company Baron Advisors in New York. “When niche players occupy a space where other people aren’t looking, they have a higher likelihood of uncovering situations where they can exploit inefficiencies in a market and derive a significant return.”

Small Wonders
Specialist funds have always been an important segment of the alternative arena, but the relatively poor performance last year of hedge fund indices, which generally measure the performance of established and larger funds, has led to a flurry of activity in the niche area. “More people are looking at weather derivatives, at emissions derivatives, at renewables and all these kinds of things,” says Pierre Aury, London-based managing director with Clarksons Capital (a division of the integrated shipping services company Clarksons) and manager of its new fund. The fund, called Clarksons Shipping Hedge Fund, will trade freight derivatives and take directional bets on shipping company stocks.

TOP VIEW: In a hedge fund market where too much money now chases a dwindling number of opportunities, smaller niche funds are delivering returns that larger funds can no longer achieve. By focusing on relatively unknown markets, niche players adopt newer strategies and often enjoy a near monopoly in the space. There is, however, risk involved: These funds may well be operating in very volatile markets, or they may be making very illiquid investments. Experts advise that niche investors proceed with caution.

Aury believes that large, established funds are now at a disadvantage. “Most of the strategies used by the hedge funds that we’ve studied recently involve putting very good brains on the same investment universe, and as a result, all the inefficiencies are disappearing,” he says.

Managers of the new Clarksons fund, which seeks to generate absolute returns of 15 to 20 percent annually from a capital base of $200 million to $300 million, hope to beat larger hedge fund competitors by using the company’s expert knowledge of the shipping sector. “Information in this market is easily accessible to people from shipping, but not easily accessible to people from outside, so this creates a barrier to entry,” Aury says. This may give Clarksons a strong position when trading the inefficiencies in the shipping sector, at least for a time. “At the moment, I think we will be the only one harvesting that low-hanging fruit,” Aury adds.

Compare this to the convertible arbitrage market in which funds invest in convertible bonds to obtain the embedded stock options, while selling short the underlying stock and hedging out the credit risk of the bond itself. This strategy depends on persistently high equity market volatility, which increases the value of the embedded options. (Indeed, many standard hedge fund strategies glean their value from equity volatility.) But in the last year, the equity markets have been anything but volatile. In mid-December, the Chicago Board Options Exchange’s VIX index of S&P 500 implied volatility was hovering a mere point above its 52-week low. According to Aury, the shipping market, by contrast, is extremely volatile, which means there are plenty of opportunities to generate the excess returns that hedge fund investors seek.

Some hedge funds of funds are now turning to niche fund investments. London-based PSolve Alternative Investments, for example, launched a fund in December that specifically targets niche areas. Called the Niche Opportunities Fund, it invests in roughly 20 underlying specialist hedge funds, including ones that target the Asian property market, and a fund that focuses on the financing and trading of manufactured housing. As with Clarksons, the fund will seek to generate absolute annual returns of 15 to 20 percent. “I think the money in hedge funds is going back to where hedge funds began, which is smart guys playing a niche,” says Soondra Appavoo, PSolve’s London-based managing director. “If you are playing a niche, then you are more likely to make money than playing in generalities.” He adds, “There are loads of great hedge fund managers out there playing small defendable niches that other people simply aren’t looking at yet.”

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.

Additional Information
 Small is Beautiful