Michael Rowland is the Commonfund Institute Summer Intern. He is a rising senior at Case Western Reserve University. He is majoring in Finance and Accounting.
What are Diverse and Emerging Manager Programs?
In order to adequately and fairly evaluate the success of emerging and diverse manager programs, the term ‘emerging manager’ needs to be clearly differentiated from ‘diverse manager’. While there is no formal definition, ‘emerging manager’ refers to a firm with a cap on assets under management. This cap varies widely depending on the investing organization, but usually sits around the $1 billion mark. By contrast, ‘diverse manager’ generally refers to any minority- or women-owned firm. Given these distinctions, a diverse manager is not necessarily emerging, and an emerging manager is not necessarily defined by race, gender, or any other characteristic other than being a smaller fund seeking opportunities to grow. Although diverse managers can, and are oftentimes, identified as emerging given their fund sizes, the interchangeability of these terms obfuscates the implementation and evaluation of their success.
Do Emerging and Diverse Manager Programs Improve Performance?
Considerable evidence exists that emerging managers generate higher returns. Studies show that there is significant alpha generation in the early stages of firm size, dubbed the ‘small firm effect.’1
A plethora of historical data affirms this correlation. According to a study conducted by Prequin, “emerging funds (less than three years old) earned an average of 12.2% versus the overall hedge fund industry’s return of 7.7% annually over a recent five-year time-frame (as of May 2017).”2,3
This outperformance is thought by many to be the result of two potential advantages. First, emerging manager’s small size may allow them to be much nimbler, enabling them to respond much more efficiently to market changes as compared to their larger counterparts. Second, emerging funds may be able to tap into market niches, which could allow them to exploit market inefficiencies. This precedent of emerging managers outperforming established funds drives a lot of the conversation advocating for emerging manager investments.
Contrarily, the results are much more mixed for diverse managers. Harvard Business School Professor, Josh Lerner, explores this correlation in his 2018 Diverse Asset Management Firm Assessment. In his analysis of mutual funds, Lerner concludes that “the performance of funds managed by diverse-owned firms is statistically no different than the performance of funds managed by non-diverse firms.”4
Lerner comes to a similar conclusion for hedge funds, stating that “we find no conclusive evidence that the performance of diverse-owned hedge funds differ significantly from the performance of non-diverse funds,” and comes to the same conclusion for private equity and real estate firms; “Among PE asset managers, we find little evidence that women- or minority-ownership impacts fund returns.” The evidence suggests that diverse managers are in-line with broader industry averages.
While no statistically significant excess returns may be generated from diverse manager programs, that does not diminish their importance. In his study, Lerner also explores the capital disparity among women and minorities in the field of asset management. For mutual funds, while women represent 9.9 percent of firms, they only manage 0.8 percent of industry assets. The disparity is even higher for minorities, who represent 8.8 percent of firms, but manage a mere 0.4 percent of industry assets. These disparities exist in every asset class Lerner explores, including hedge funds, private equity funds, venture capital funds, and real estate funds.
The field of finance is known for its homogenous, white male demographics. Only in the past two decades have considerable efforts been made in the fields of diversity and inclusion. As such, one of the largest inequalities facing the industry is capital allocation. Contributing capital to these underrepresented and underfunded groups will help close the disparity seen in asset management’s capital allocation, creating a more equitable industry.
What Challenges Face Diverse and emerging Manager Programs?
Some organizations have seen great success from emerging manager programs while others have reported less than satisfactory results. One of the largest pitfalls of creating an emerging and diverse manager program is falling victim to adverse selection; creating restrictions that limit the type of potential money managers and severely decreasing the pool of managers. For example, one problematic restriction for institutions is narrowing the geography of potential managers to a particular state or region. This restriction is incredibly limiting to smaller states, especially in regions where financial services is not as prevalent an industry or where there is a limited supply of managers across asset classes. This requirement severely limits the number of potential managers and can lead to subpar returns. It is imperative that the parameters surrounding the program be flexible to mitigate potential issues. Some institutions have been so hindered by restrictive guidelines that they had to either cancel or restructure their program. Other organizations, who have been wary of this threat, realize great success from flexible, well-structured emerging and diverse manager programs.
How Can Organizations Create Effective Programs?
Emerging and diverse manager programs can be effective, but they need to be structured carefully to realize the potential benefits. The National Association of Investment Companies (NAIC), an organization dedicated to the promotion of emerging manager programs, released a 2011 best practices report detailing seven critical success factors of an emerging manager program. For a program to be successful, the organization must have:
- The top management commitment and support
- Clearly stated goal and objectives
- Well-structured and clear definitions of ‘emerging manager’
- Strong, knowledgeable leadership of the overall program
- An innovative and well-conceived program
- Experienced strategic partners with proven track records
- Broad outreach to the emerging manager community
For firms and funds interested in creating emerging manager programs, it is essential to explicitly define who you are targeting with your program, create a concrete implementation plan, develop fair and commensurate evaluative frameworks, and review the success and failure of various program structures accordingly. If executed correctly, emerging and diverse manager programs can certainly be worth the investment.
What is the Future of Emerging and Diverse Manager Programs?
For emerging managers, the investment management industry collectively accepts them as vehicles of excess return. There has already been a significant amount of capital flowing into these small firms.
As diversity initiatives gain more prevalence, you can expect to see more investments in diverse managers. Social inequalities continue to persist, and the investment management industry has an opportunity to make a difference in ensuring the equitable allocation of capital.
The data shows us that emerging and diverse manager programs create a larger investment opportunity set and our social justice sensibilities tell us that this is the right thing to do; both programs are worth doing, and worth doing well.