emerging managers: small firms with big ideas

DECEMBER 2014Callan InvEstMEnts InstItutE

Ask the Expert

Everybody has to start somewhere, including investment managers. Even the largest firms with broad name recognition and substantial assets were once emerging firms. Emerging managers generally include smaller and newer investment managers, poten-tially with atypical ownership structures. While smaller asset pools can work against them in some cases, it can also work in their favor, enabling them to access opportuni-ties that larger, more established investment managers cannot.

Many u.s. institutional investors have long track records of dedicated investments with emerging managers while others are just starting to examine the space. Emerging manager programs are becoming more commonplace, particularly at public pension funds, as investors recognize the potential portfolio gains that can be achieved through investing with the diverse and entrepreneurial investment managers that make up the emerging manager space.

Callan has long recognized the value that diversity of professionals and firm size can bring to investment outcomes. Our founder Ed Callan was instrumental in launching Progress Investment Management more than two decades ago. In 2010, we launched Callan Connects to expand our universe of emerging manager and minority, women, and disabled owned firms. In this interview, Uvan Tseng talks with Lauren Mathias, who oversees Callan Connects, about trends and issues in the emerging manager arena.

A Conversation with

Lauren Mathias, CFA,

Vice President

Interviewed by

Uvan Tseng, CFA,

Vice President

Emerging Managers

small Firms with Big Ideas

2

Uvan Whatisthedefinitionofanemergingmanagerandwheredominority,women,anddisabled,ownedfirmsfitintothatdefinition?

Lauren The definition of an emerging manager varies pretty widely throughout the industry. The most prevalent

definition is by assets under management, but investors will also often consider the length of the desired

strategy’s track record, ownership structure, and ethnicity of the key professionals with ownership in the firm.

In terms of the longevity of the desired strategy, less than three years is generally considered an emerging

strategy or emerging firm. Looking at firm-wide assets under management, the most common range that

I’ve seen is a maximum of between $2 and $3 billion. However, this maximum could be flexible when other

factors are looked at simultaneously. For example, for our Callan Connects program, which is Callan’s out-

reach program for meeting with new emerging managers and building our research, we define emerging

managers as those with less than $3 billion in assets, but for firms that are minority, women, or disabled

owned the maximum is $10 billion. To qualify as majority minority, women, or disabled owned, the firm must

be at least 51% owned by these persons. Emerging managers can also obtain a certification verifying their

minority or women owned status, which further clarifies the definition

We use this definition because some of our large public fund clients that are dedicated to investing in the emerg-

ing manager space, as well as in minority, women, and disabled, owned firms, utilize these qualifications.

Uvan Whataresomeofthemainreasonstoinvestinemergingmanagers?

Lauren the short answer is performance. I’ve seen a lot of research, over multiple historical time periods, which

show smaller managers tend to outperform larger managers.

Additionally, if an investor includes minority, women, and disabled, owned firms as part of the emerging

manager definition, then the motivation might also be to further diversify their program or better represent

the beneficiaries of their fund.

Uvan Whenyoulookatemergingmanagersasagroup,dotheyoutperformestablishedmanagersacrosstheboard?

Lauren not necessarily; it often depends on the asset class. there’s not one aggregate number that says emerging

managers beat established managers. In general, smaller managers tend to outperform, but the capacity

constrained asset classes are really where they add the most value. smaller managers have the poten-

tial to outperform more established managers because of their nimbleness. Capacity constrained asset

classes are where smaller managers have more agility when investing versus larger firms with greater

assets under management.

CallanConnects

We launched Callan Connects in 2010 to expand our universe of emerging managers and minority, women, and disabled owned (MWDO) firms. We reserve one day each quarter to meet with emerg-ing managers with less than $3 billion in assets and MWDO firms with less than $10 billion to intro-duce their firms to Callan. We hold meetings in major U.S. cities to minimize travel for firms in or near these locations. Since inception, 196 firms have participated in Callan Connects.*

*A complete list of participating firms is available at www.callan.com/datatools/connects/

3Knowledge.Experience.Integrity.

Other 3%

Alternatives 16%

Non-U.S. Fixed Income 1%

Global/Non-U.S. Equity 17%

U.S. Fixed Income 18%

U.S. Equity 45%Minority 62%Women 34%

Disabled 4%

Uvan Doyouthinkinvestorsshouldevaluateemergingmanagersdifferentlythanestablishedmanagers?

Lauren Yes, I do think that clients should evaluate emerging managers somewhat differently than established

managers.

Specific areas to consider include:

• Firm structure: It’s important to understand the emerging manager’s asset base; if it’s working capital,

how long will it last? If the firm already has clients, is the client base diversified? If not, do they have a

plan to grow the client base?

• Key professionals and ownership: Who are the key professionals and what is their ownership in the firm?

Have they worked together a long time or are they a new group? Do they have experience in managing

a business as well investments? Emerging managers will be running the business and handling invest-

ment decisions. And lastly, how are the professionals compensated—specifically, are they incentivized

by the success of the firm?

• Resources: It’s important to understand that a lot of the new emerging manager firms come from estab-

lished firms where resources were simply provided for them, and now as a smaller firm they need to

establish their own. How do the key professionals divide the tasks of building and operating the business

versus the investment management? Most importantly, is there a separate compliance officer, and who

do they report to? Which functions are outsourced? Do they have insurance policies and contingency

plans in place? a lot of the things that you may not think of for established managers are really important

to consider for a newer firm.

In terms of measuring success, it’s important that results are commensurate with initial expectations. For

example, if the manager is implementing a large cap growth strategy, is the portfolio doing well when large

cap is doing well? When growth is doing well? Consistency in the process and the results is a good mea-

sure of success for both emerging and established managers.

MWDOFirmsbyOwnershipType MWDOFirmOfferingsbyBroadAssetClass

Source: Callan database

Asian: 28%African American: 43%Hispanic or Latino: 20%Subcontinent Asian: 6%American Indian & Alaska Native: 1%Native Hawaiian & Pacific Islander: 1%

4

Uvan Howdoesperformancemeasurementdifferforemergingmanagersthatofferprivatestrategies?Iexpectitwouldbemorechallenginggiventhelonger-termnatureofprivateinvestmentsrequiresthatthefirmhasalongertrackrecordthanmostemergingmanagerstobeabletomeasurethesuccess.

Lauren the same qualitative questioning applies to private and public investments, but the measure of success is

going to be considered over a different time frame. Private investments require a much longer time period

to analyze consistency.

One way to deal with short-term measurement for emerging managers of private strategies is to consider

the key professionals’ historical track records. They may have come from larger firms, and you can look

at their previous achievements and track records to help set an expectation for potential performance at

the newer, smaller firm. If they don’t have a track record from a previous firm, then a good understanding

of all the other aspects of the emerging firm and the market opportunity for their strategy will help, as well

as watching performance as the firm builds its private investment track record. Investing with emerging

managers in private asset classes generally requires accepting that there will be limited realized track

records to analyze.

Uvan Whatkindsofinvestorstypicallyseekoutemergingmanagers?

Lauren Historically a few large state pension funds and large endowments have driven interest in emerging

manager investment, but awareness and implementation continue to grow for other state pension funds,

public utilities, and other funds, as well. In fact, other types of investors are starting to take notice. the

early investors’ success with emerging managers has led to interest outside of the public fund space.

Corporations seeking diversification are now interested, and recently I’ve seen private wealth investors

showing increased interest in utilizing emerging managers for their retail client base.

Uvan Whyhasinterestinemergingmanagersblossomedinthelastfewyears?

Lauren I think it has taken time for the early adopters—the large state pension funds and endowments—to show

the success of their investments in emerging managers. Establishing a “track record” of investing with

positive results has shown other investors that it’s an effective space in which to invest. at the end of the

day, fund sponsors need investment results; in some cases emerging managers have provided that perfor-

mance edge over the more established managers.

Additionally, since the 2008 financial crisis, fund sponsors have worked to diversify their investments. Most

of that diversification has come by asset class, but many are looking at varying ownership structures or

sizes of investment firms, where emerging managers can play a role.


Uvan Whatarethemorepopularstrategiesthatemergingmanagersoffer?

Lauren Emerging managers offer basically the same strategies that a traditional established firm would offer: equi-

ties, real estate, private equity, hedge funds, etc. u.s. equity tends to be the most prevalent, followed by

some alternative asset classes, such as private equity and hedge funds. More recently, I’ve seen a growing

number of product offerings for real estate and non-u.s. equity.

The one outlier in this group is fixed income, where there are fewer product options from the emerging

manager space. the established manager community is a smaller group; it’s a challenging asset class

to manage with little resources. I think that’s why u.s. equity tends to be the most prevalent—it’s a liquid

space with information that is accessible to many, while fixed income is a more challenging and resource-

heavy process to manage when you’re smaller.

Uvan Itseemslikeoneofthebiggestchallengesforemergingmanagersisthelackofresourcestobeabletobuildamorestablefirm.Yetmostprospectsarenotcomfortableinvestingwiththemuntiltheybecomebiggerandmorestable.Whatdoyouthinkaresomeofthebestwaysforemergingmanagerstogetaroundthiscatch22?

Lauren Emerging managers that have come from the more established firms are used to working with an institu-

tional client base. There’s the expectation that these same investors will be their first clients at this new

smaller firm. But as you mentioned, it’s difficult given the size of these emerging managers for institutions

to invest in these smaller firms when the mandate sizes are much larger than the smaller firms can take at

the onset. Investors also consider the business risk of asset concentration, and don’t want to represent too

large a percentage of any one manager’s assets.

One way of getting around this catch 22 would be for the emerging managers to consider other investor

types. I mentioned earlier the interest coming from private wealth investors, so considering retail inves-

tors through that avenue, or even sub-advising opportunities, where the mandate sizes in both of these

examples are typically smaller. they also have the option of working with manager-of-manager programs

to help them get a few dollars in the door and get the ball rolling.

Uvan Isamanager-of-managersprogramthemosttypicalwayforinvestorstoaccessemergingmanag-ers,ordoyouseemoredirectinvestments?

Lauren Investors have a couple of options. The first is direct investment with the emerging manager. This method

is sometimes challenging for large plans because the dollar amount they want to invest tends to be too

much for smaller managers to take on. to work around this issue, a large plan could create a portfolio of

several emerging managers, essentially creating an emerging manager program. this program allocates

smaller dollar amounts to multiple emerging managers. Investors that take this approach often have sub-

stantial internal resources in order to evaluate the emerging managers prior to investing with them and

manage the program over time.

Investors that don’t have the resources to research, evaluate, and monitor emerging managers directly can

look to managers-of-managers for access. These firms create multi-emerging manager strategies—essen-

tially custom portfolios for the investor. Manager-of-managers firms have the experience and the resources

to dedicate to these portfolios on behalf of the investor.

6

Uvan Beyond meeting with manager-of-managers platforms and attending a Callan Connects typeprogram, are there any actions that you would recommend for emergingmanagers tomarketthemselves?

Lauren this is an incredible challenge for emerging managers, because the professionals that are managing the

firm have to wear multiple hats: portfolio manager, CEO, trader, marketer, etc. It’s hard to find the time

to establish marketplace familiarity with the firm. Conferences are great places to meet with prospective

clients and consultants as an introduction. several emerging manager organizations exist that help par-

ticipating firms learn more about industry trends. Emerging managers can directly contact consultants, as

well. For example, Callan encourages emerging managers to attend a Callan Connects meeting, or directly

email or call someone in our research group. Emerging managers can also directly contact potential cli-

ents, as well.

It’s important to understand your audience before marketing a strategy. Institutional investors and con-

sultants are short on time, so the emerging manager needs to know exactly what they have to offer,

whether or not that strategy appeals to the institutional investor or the consultant, and package that in a

concise way.

Uvan Whatdoyouthinkisthebestwayforemergingmanagerstodeterminewhetherornotthatstrategyappealstoaninstitutionalaudience?

Lauren I recommend a quick initial email or phone call to introduce the strategy. For example, an emerging man-

ager covering international small cap might email consultants a brief introduction to the strategy. they

might reach out to a smaller consulting firm with a limited client base and discover that the consulting firm

doesn’t recommend investing in international small cap to its clients. In this example, setting up a full hour

meeting about international small cap wouldn’t be a good use of either parties’ time if that’s not an asset

class that the consultant would ever recommend to their clients. a brief introductory email or phone call

could help emerging managers spend their time more efficiently, with a focus on contacts that have interest

in their product offerings.

Uvan I’dimaginethatmostemergingmanagersofferseparateaccountstostartoff.Howimportantdoyouthinkitisthoughtobeabletoofferothervehicles,likecommingledormutualfunds,intermsofhelpingthemmarket?

Lauren When considering vehicles, it’s important for all managers to have several options. We’re finding that a lot

of our clients have multiple plans that often require different vehicles. unfortunately, that can come at a cost

for an emerging manager.

Starting out offering separate accounts is the most efficient way. Then over time, as they start to build

assets and revenues, they can consider some of the more costly options (e.g., mutual funds, collective

vehicles).


Uvan Youobviouslymeetwithalotofemergingmanagers.Arethereanycommontraitsthatyouseeamongtheemergingmanagersthathavebeenalittlemoresuccessfulatmaybecrossingovertobecomeestablishedmanagers,or just theones thathavebeenverysuccessful ingrowingassets?

Lauren I’ve noticed a few general characteristics about firms that have made them successful: consistency, dedi-

cation, confidence, and integrity. As it pertains to emerging managers, consistency and dedication are

extremely important. they’re going to face multiple challenges, the catch 22 you mentioned, market hic-

cups, or client reallocations leading to asset fluctuations. It’s going to be a challenging road, but if they’re

consistent and dedicated to what they’re doing, then they have the ability to see through those hiccups and

hopefully do well in the long term.

You have to have the confidence to know that if you are consistent and dedicated that it will eventually pay

off. I say integrity because the best managers are ones that have successful long-term relationships with

their clients, and trust is an important part of it.

Minority,Women,andDisabled-OwnedFirmsBytheNumbers

number of distinct portfolios managed by minority, women, and disabled owned firms for Callan clients

228

number of distinct investment strategies within Callan’s proprietary database managed by firms classified as MWDO

number of emerging and MWDO firms that have participated in Callan Connects**

750+

196

number of Callan clients utilizing MWDO firms 52

Number of firms classified as MWDO in Callan’s database

number of all Callan meetings with MWDO firms in 2014*

263

96

Assets managed by MWDO firms for Callan clients$23B

as of september 30, 2014, unless another date is indicated.

*Through October 31, 2014. Includes MWDO meetings through Callan Connects.**Since inception in May 2010


Uvan Assomeonewhofrequentlymeetswithandevaluatesemergingmanagers,whatdoyoulookattoassessanemergingmanager’sdedicationtostayinginbusinessinthelong-term?

Lauren I think of it from two different perspectives: qualitative and quantitative. Qualitatively, I look for an entre-

preneurial spirit, excitement about investing, and confidence about their particular process and strategy. I

ask about their plans for the future in terms of growing their staff, adding a trader, marketing to a new client

base, or creating another strategy. You can tell from an emerging manager’s forward-looking plans (or lack

thereof) whether or not they’re dedicated to it.

Quantitatively, I look at compensation and ownership structures. Ideally the key decision makers are part-

ners and/or majority owners, and if possible they’re also invested in their portfolio. I think you can feel

pretty confident about an emerging manager staying in business in the long term if those qualitative and

quantitative aspects align.

Uvan Lookingatinvestorswithdedicatedemergingmanagerprogramswithinthetotalportfolio,howdothey“transition”amanageroutoftheemergingmanagerportfolio?Haveyouseenaconsistentapproach,ordoesitreallydependontheinvestorhoworifthey“graduate”emergingmanagers?

Lauren It varies by investor, depending on whether or not they have an emerging manager program. If they like

the manager, in most cases I’ve seen clients find a space for them within their general lineup. Investors

with a dedicated program essentially have a certain asset allocation earmarked for emerging managers.

If a manager within that program no longer meets that definition—they have been successful and have

grown their business beyond the assets dictated by the emerging manager definition—then they typically

will not be a part of the program anymore. If the fund wants to continue to invest with this manager, then

it is most common for them to move out of the emerging manager program to be classified with the rest of

the fund’s managers.

But if the investor doesn’t have a defined emerging manager program, then there isn’t necessarily a need

for graduation; the emerging manager just becomes established and perhaps is given more assets in the

overall plan.

GetConnected

there is no fee to participate in Callan’s database. Information about our online question-naire can be found on our website (www.callan.com) under Manager Questionnaire.

To submit your firm to Callan’s Manager Database, please send the following information to [email protected]:

1. Full legal name of the firm and mailing address of the main office.

2.Contact information for a business/marketing individual and a database/questionnaire individual.

3.name of the strategy to be included in the database.

4.strategy’s quarterly returns and vehicle type.

We will respond with a manager questionnaire login once you have submitted this information.


Uvan Towrapup,anypartingwordsofadviceforemergingmanagers?Iknowitcanbeverychallenginganddishearteningsometimestobeabletoforceyourselftostaydedicatedgivenallthechallengesofoperatinginthatspace.

Lauren Exercise patience. I’ve seen successful emerging managers that can put their heads up when they need

to: go to the conferences, send emails, make folks aware of who they are. But they put their heads down

when they need to, and they outperform and deliver consistently in their process. It takes patience to do

those two things for a longer time than you necessarily want to, especially with that entrepreneurial spirit,

drive, dedication, and excitement. It’s hard to have patience over time to know that when you do well, cli-

ents will come to you and the business will grow organically.

I would urge emerging managers to be consistent, dedicated, and patient, because those are the traits that

I’ve seen in the most successful emerging managers.

Uvan Goodadvicethatwecouldallapplytoourwork!Thankyouverymuchforyourtime,Lauren.

Lauren thank you, uvan!


Biographies

Lauren E. Mathias, CFA, is a vice President and u.s. equity investment consultant

in Callan’s Global Manager Research group. lauren is responsible for research and

analysis of u.s. equity investment managers and assists plan sponsor clients with

u.s. equity manager searches. In this role, lauren meets regularly with investment

managers to develop an understanding of their strategies, products, investment poli-

cies and organizational structures. lauren also oversees the Callan Connects pro-

gram, launched in 2010, which enhances Callan’s coverage of emerging managers

and minority, women, and disabled-owned firms. Lauren is a shareholder of the firm.

lauren joined Callan’s Client Report services group as an analyst in October 2004. Prior to Callan, she

assisted an independent financial planner in preparing financial plans for individual investors.

lauren graduated from California Polytechnic state university, san luis Obispo in June 2004, Magna

Cum laude with a Bs in Business administration, concentrating in Financial Management and Enterprise

accounting with a minor in statistics. she has earned the right to use the Chartered Financial analyst

designation.

Uvan Tseng, CFA, is a vice President in Callan’s san Francisco Fund sponsor

Consulting office. Uvan works with a variety of fund sponsor clients including corpo-

rate defined contribution plans and corporate and public pension plans. His respon-

sibilities include client service, investment manager reviews, performance measure-

ment, research and continuing education, business development and coordination of

special client proposals and requests. He joined Callan in 2008 and is a shareholder

of the firm.

Prior to joining Callan, uvan held positions as a Research analyst/associate Portfolio Manager at armory

advisors and as an associate Portfolio Manager at Fan asset Management. Prior to that, he was a Financial

advisor with Morgan stanley. uvan began his career at Franklin templeton in the corporate management

training program.

uvan earned an MBa in Finance from santa Clara university and a Ba in Business Economics from the

university of California, santa Barbara. uvan has earned the right to use the Chartered Financial analyst

designation and is a member of CFa Institute and the CFa society of san Francisco.

11

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emerging managers: small firms with big ideas

Economy & Finance