Our Napa Valley shuttle driver offered a surprising insight: "You’ve chosen all the big wineries but not necessarily the best wines or the most memorable experiences. May I suggest a few lesser-known producers where you’ll taste the difference and appreciate their craft?”
He was absolutely right, and like wine, the best investments are often made by off-the-beaten-path producers. Yet even in this environment - where truly intriguing investment opportunities are scarce - many investors continue to default to the familiar brands and large funds, despite strong evidence pointing elsewhere.
Why smaller managers win
Research shows that small and emerging fund managers often outperform the large, household name peers, across asset classes, by a significant margin and with less risk.
A recent Morningstar report compares ten years of risk and return data for five of the largest fixed income funds in Canada to five funds from smaller but established Canadian FI managers. The report shows that the smaller funds outperformed by more than 3 per cent per year, on average, with similar volatility, higher risk-adjusted return, and better protection in down markets. Its results reinforce this 2023 Morningstar article.
A 2024 PitchBook Analyst Note: Establishing a Case for Emerging Managers, concluded that “the top emerging managers in multiple strategies can offer higher upside potential than tried-and-true firms.” The report examines performance trends across buyout, venture, real estate, and private debt funds.
Similarly, a 2023 Axios article titled Smaller venture funds continue to outperform the largest ones cites a U.S. study of almost 1,400 venture capital funds from 1979-2018, using PitchBook data. A BeachHead study calculates that “small funds outperformed large funds by 254 basis points annually over 5 years, and 220 basis points over 10 years.”
Further, a 2020 article in Institutional Investor titled “Large Managers Get the Money, but Small Managers Provide the Performance” discusses how large managers end up producing beta (volatility versus a benchmark) while smaller managers have better opportunities to find alpha (excess returns versus a benchmark), yet the larger ones are still more likely to raise capital.
Certainly not all smaller funds outperform, and not all the time. But more than enough of them, in Canada and globally, across asset classes, with sufficient frequency, can offer an edge. The track record of enough smaller funds and fund managers, in Canada and globally, supports the proposal that they can improve investment portfolios.
In our search for alpha, we gravitate to the largest managers when sometimes we should be looking to the smaller, nimbler ones.
The issue with bias
There are two main reasons why this opportunity for outperformance isn’t better known, and one subtle nuance.
Reason #1: Visibility isn’t performance
Smaller managers lack the stature, brand equity, and marketing budgets of their large competitors. Yet many offer similarly registered investments and operate under the same regulatory standards, while delivering superior results with demonstrable track records. Market awareness, not quality or opportunity, limits their asset growth.
Reason #2: Familiarity Breeds Comfort
We all know the large fund companies and banks. Their visibility gives us comfort: the conferences, the reports, the branded swag. But this halo effect dulls our critical thinking. Even when these big names underperform, we give them the benefit of the doubt while overlooking better-performing yet lesser-known managers.
The nuance: Structural inertia
Consultants, advisers, outsourced investment management, and institutional allocators often stick to big names due to business model constraints. Their fee structures, scalability needs, and capacity limitations make it hard to research or deploy small and emerging managers, even when they want to.
Further, they can fall victim to the erroneous adage that underperformance by a large, established manager is acceptable. Ironically, these forces entrench the bias further, reinforcing the asset under management dominance of underperforming incumbents.
What can we do?
Most worthwhile small and emerging managers have properly registered funds with enviable track records, conveniently available on Fundserv and across most bank shelves. Yet they’re neglected by our outdated allocation process and our bias for familiarity and scale.
Redesigning your process
To capitalize on this opportunity, consider broadening your due diligence scope. Ask your adviser for both known and lesser-known fund options. Seek managers who provide transparency, focus, and alignment. Find the managers who can exploit opportunities that are too small for the giants.
Look for:
- Strong alignment of interests and skin in the game. Smaller managers tend to own their firms and/or have high employee ownership.
- Targeted strategies with a defined edge. Smaller managers have the luxury of focusing on a specific and often small themes or anomalies that are just too small for large managers to exploit sufficiently - so they skip it, leaving valuable opportunities for smaller managers. You want that relative value opportunity in your portfolio, and you need to explore the smaller managers to get it.
- Smaller size allowing nimbleness and alpha capture
- Sufficient runway for growth without style drift
- More transparent, collaborative relationships
A Word for the Allocators
A recent foundation RFP process revealed the limitations of many “open architecture” firms, where in practice they rely upon a shockingly short list of large managers. Meanwhile, “closed architecture” advisors excluded external funds entirely, negating this small and emerging manager opportunity.
The issue isn’t a lack of desire to perform, but logistics: cost of manager coverage, lack of scalability, and percentage of ownership rules. But here lies the opportunity.
These large allocators could improve returns by:
· Building distinct small-manager pools
· Launching fund-of-fund sleeves
· Creating hybrid sleeves, enabling the smaller-fund additions to complement their larger funds
This approach could enhance returns and diversify exposures, and it could even reverse the unfortunate reputation for “good governance, weak returns”. It might also provide a welcome solution to the trend of competing on fees alone.
Outperformance awaits
We crave bespoke experiences in most areas of life. Yet when it comes to investing, we often choose the big and well-known.
That comfort comes at a cost.
The return, diversification, and risk mitigation opportunity with smaller and emerging managers is well-documented, underutilized, and ripe for exploitation.
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. Kevin.Foley@YTMCapital.com