Hedge fund start-up - if you are in a cold style, you will have to work harder and have more skill

There is always strong interest in hedge fund start-ups because investors are looking for the next hot manager with extraordinary skill. It is like the drafting of players in professional sports. Existing players are known quantities but drafting from college may get you the next superstar. Of course, many do not work out or realize this potential. More importantly, there is no hedge fund draft. Investors and managers have to find each other through search and have to conduct private due diligence.

A recent paper has focused on the hedge fund start-up market with a novel approach for analysis, see “The Economics of Hedge Fund Start-ups: Theory and Empirical Evidence”. The paper starts with a simple framework where capital is raised through what it refers to as extensive and intensive margin. Capital raised from the extensive margin is gained through the matching of investor and manager through search. Intensive margin is the acquiring of capital by managers through due diligence process and analysis of skill. 

Fund families will arise to mitigate the friction and reduce the probability of failure in raising assets as a function of skill. If a fund family can reduce search frictions to acquire assets through their brand and network, then there may be less emphasis on skill as the determining factor for raising assets. 

The market environment can either be cold or hot for a given strategy. If the market is hot, the focus is on search. There is a bandwagon effect and investors want to hold more suspected winners. When the market is cold, the investor focus is more skill than searching for managers in hot styles. This stylized approach suggests that managers must get or have more skill when they face low investor demand. 

Capital acquisition is more than just simple search. Managers must earn the trust and respect of investors when there is a low demand environment. In a cold market new funds will often outperform existing hedge funds and hot inceptions meeting high demand. Similarly, in a cold market, new managers will outperform all types of managers because they must show skill as the key to asset raising. 

A lot of work has gone into this paper to validate some simple marketing 101 concepts. If you are in a hot sector where there is a lot of investor demand you don't have to be better than style peers and other managers. The market will find you. If you are in a cold market, you better have a better process and performance because investors will not be looking for you and will be more reluctant to provide capital. Better to be style lucky as a new manager. If a manager is not style lucky, he is going to have to work harder and be better. It shows in the numbers.