“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.”