“Money flowing to managers that are so large means that their approach will be more beta than anything else, and their returns will be restricted,” says PivotalPath CEO Jon Caplis in an Institutional Investor article. “Smaller managers will get smaller and smaller on a relative basis, but they’ll be able to generate unique performance and do interesting things....The bigger guys can’t do it, but they can raise more capital.”
In our previous piece, Why smaller funds often are the outperformers, we established that smaller funds and fund managers offer coveted opportunities for outperformance. Yet, despite this, large managers tend to dominate asset growth.
In this follow-up, we dig deeper - highlighting the mechanics and behavioral elements that can give smaller managers a distinct edge. If you’re building or advising on a portfolio, this is a framework to reconsider smaller funds in your capital allocation.
Let’s start with a reminder: access to smaller funds is typically no more complex than with large ones. Most are readily available on standard platforms and are offered in the same prospectus or offering memorandum formats. Now let’s dig into the differentiators.
Skin in the game
Smaller managers often have high employee ownership - in the firm and in the funds. That alignment creates urgency, care, and a direct line between decision-making and outcomes. It also creates inherent cost control. These managers know that performance, not marketing, drives growth, and that they need that growth to survive and thrive.
Fund structure and niche expertise
Smaller funds tend to be built around a clear, defined edge: a sector (student housing), an asset class (investment-grade credit), or even a strategy type (music royalties). This clarity of purpose often enhances both due diligence and performance. A good example: a corporate credit fund that removes interest rate risk entirely, run by a manager with deep credit experience, cultivated market access, and a proven track record.
Tools
Larger funds often stick with long-only exposures, sometimes mirroring benchmarks. Smaller funds are more likely to embed tools like shorting, hedging, leverage, and derivatives - creating opportunities for better precision and performance. They often benefit from the efficiency of a prime broker. Crucially, these tools are applied within a strategy-specific context, not solely for directional bets or to mimic an index as many larger funds often do. These additional tools equip the smaller manager to be more prescriptive and nimbler.
Benchmarks, as tools, not targets. Bigger opportunity set
Many smaller managers use benchmarks for reference but not for replication, while many of the larger funds hope to simply beat a benchmark by 50 basis points, even if that is a negative return. By aiming for the best exposures within a strategy, rather than largely mirroring an index, the smaller managers create natural opportunity for outperformance. They select these opportunities from a larger pool, which is often less researched and undervalued. These select exposures also introduce desirable uncorrelated returns and often better total portfolio risk outcomes.
Absolute return
This topic overlaps with benchmarking above. Many smaller funds are established to be absolute return focused, meaning that they plan to produce positive returns in all market environments, not simply deliver the index. Absolute return frames fund manager risk and thought process, tending to produce lower volatility and lower correlation, and stabilization, which are all great for portfolios. Thoughtful security selection and position sizing reflect a deep commitment to capital preservation and compounding.
Active management
Without the constraint of benchmark mirroring, small active managers can make high-conviction calls, trim risk, and rotate quickly. Their fund structures are often designed to facilitate agility - allowing them to move in and out of positions that large funds might not be able to meaningfully access or position effectively for their portfolio size. These curated exposures differentiate small manager agility, when on offence or defence. Too often, active management in large funds is inherent housekeeping in lieu of productive portfolio management.
Runway
As large funds grow, style drift can become an issue. Smaller managers, still within their optimal capacity zone, can stay true to their investment thesis and position sizing discipline. They don’t need to expand mandates to accommodate inflows. Sufficient runway bolsters effective active and absolute return efforts.
Position size, flexibility, and agility
Building on the point above, yet worth differentiating, smaller funds can act on compelling opportunities that are too small for large managers to consider – resulting in less competition. They can often accomplish this without moving market prices meaningfully. This agility, both in entering and exiting positions, often leads to better execution, a smoother path, and higher potential return.
Alpha capture
Alpha is the generation of excess return, adjusted for risk. While alpha is elusive, many of the structural elements discussed here make repeatable alpha more likely for the smaller funds and fund managers. As noted in the previous article, data supports the idea that smaller funds can outperform - even after accounting for risk.
Freedom and transparency
Finally, smaller funds often come with fewer clients, more direct communication, less benchmark constraint, greater transparency, less internal politics, and stronger client engagement and alignment. This means better-informed investors, leading to more effective portfolio design. In practice, a fund manager should care as much about their first investor as their next investor.
This article isn’t an argument against large funds. They serve an essential role, but their dominance is unfortunate. The full investing landscape is richer when smaller funds are given their due consideration. For many portfolios, a combination of large and small mandates can offer the best of both worlds: broad exposure plus high-conviction, alpha-generating managers who are invested.
Kevin Foley is managing director, Institutional Accounts, at Canadian asset manager YTM Capital. He was previously a fixed income executive at a major Canadian bank and serves on several Canadian foundation boards and investment committees. He can be reached at Kevin.Foley@YTMCapital.com