Emerging managers often struggle with a paradox. Despite their overall outperformance against their mega-fund counterparts, as well as a political push to hire managers by diversity and geography, they have just scratched the surface when it comes to winning pension assets. In order to break through that glass ceiling, understanding what plan sponsors and fund of funds managers really want when they select emerging managers is a business imperative.

Emerging managers account for 40 percent of top-quartile managers in terms of investment results, yet they have just one percent market share of pension assets, according to Larry Jones; he is the Executive Vice President and Practice Leader of Emerging and Minority programs for fund of funds manager Northern Trust Global Investments (NTGA) in Chicago. “Allocations to small managers are minimal, even though performance potential is there,” he says.

Furthermore, emerging managers may suffer from a perception problem. “The notion that all emerging managers are first-time investors or somehow inexperienced just doesn’t reflect reality,” says Thurman White, President and Chief Executice Officer of Progress Investment Management, a fund of funds manager in San Francisco. In a recent survey, some 70 percent of emerging managers in the Progress proprietary database had three or more owners, a median of 10 employees and had been in existence for 15 years or longer. Furthermore, emerging managers range across the investment spectrum among all asset classes

From the plan sponsor’s perspective, pension funds often come up against capacity issues or the size of emerging managers’ assets under management (AUM). White notes that pensions “don't want a disproportionate share of the firm’s assets since it might create some undue risk.” They must also take into account a firm’s stability and whether there is sufficient employee management and succession depth. Finally, career risk may stand in the way of emerging managers’ winning mandates. “Consultants and pension staffs really don’t have the incentive to take risk,” White says. “People are reluctant to take those chances as they try to manage their own careers.” On the flip side, he notes, hiring smaller or newer managers diversifies the portfolio and actually reduces risk.

Allan Emkin, Managing Director of Pension Consulting Alliance in Encino, Ca, who does not consider himself risk-averse, sees a lot of interest in emerging managers. “Pensions are looking for new, innovative people, with no liquidity concerns,” he says. “They want firms that aren’t tied up in historical organizations with bureaucracy, that are more flexible and creative.”

Diversity is another motive for seeking smaller firms. “The business argument for minority-owned firms is that certain groups of people have been historically overlooked, so that anyone looking for new opportunity may find it now,” Emkin says. Clayton Jue, President and Chief Investment Officer of fund of funds manager Leading Edge Investment Advisors (LEIA) in San Francisco, finds that minority- and women-owned firms comprise a meaningful portion of all emerging managers. “The percentages differ depending on how inclusive and far reaching the databases are,” he says, “but our studies show that 23 percent of 1394 managers with $2 billion or less in AUM, are minority- or women- owned. Others go as high as 32 percent.”

Pension funds are highly selective, however, and there’s a desire to foster greater competition among newer managers. “There is no reason to believe that dispersion of returns is any more assured for emerging managers than for their larger counterparts, says Emkin. “Emerging managers have done better than some large funds, but not across the board and not in every time period. There are good managers and bad ones vying for ideas. The ultimate beneficiary of competition, of course, is the investor.”

Direct Investment or Fund of Funds?
As long as emerging managers continue to outperform as a group, most plan sponsors will be receptive to making an allocation to them, although the type of initial investment will vary. Some forge a direct relationship, while others prefer a fund of funds approach. “The decision to use a fund of funds is a function of corporate staffing and internal capabilities,” says Jones. “A plan sponsor’s staff might have two to four people, while NTGA has 85 people who are part of its manager or managers program. Approximately 30 people touch a client on research, portfolio construction, client service, compliance and other areas.”

“Pensions have limited capacity to research and administrate individual investment managers,” agrees Ted Krum, Vice President for Northern Trust Global. “They also worry about business failure if small firms blow up.”

Another crucial driver for using a fund of funds manager is that pension mandates usually can’t account for more than 10 percent of a single manager’s AUM. In addition to NTGA, Leading Edge and Progress, other well-known fund of funds managers include Credit Suisse First Boston, New York, FIS, Philadelphia, and Attucks, Chicago For many pensions, funds of funds can also be good proving grounds for managers with limited track records. “Plan sponsors aim to screen managers through a fund of funds, and see which grow successfully,” says Emkin. The Teachers' Retirement System of the State of Illinois (TRS), for example, looks for firms that can graduate out of the emerging managers program and manage assets for the main fund.

The Firemen's Annuity & Benefit Fund of Chicago (CFIRE ) has invested in emerging managers for 17 years. Included among them are Brandes Investment Partners, first hired in 1992, Keeley Asset Management, hired in 1995 and Earnest Partners and Globeflex Capital hired in 2005. “We hired emerging Navellier and Associates and Brandes Investment Partners in the nineties and still invest in them currently,” says Michael Moran, CFIRE’s Chief Investment Officer. More recently, CFIRE has hired RhumbLine Advisers and Logan Capital Management. Rhumbline, an African-American index manager, is also one of the Los Angeles City Employees' Retirement System (LACERS) longest running manager relationships.

“Interestingly, pensions will sometimes use the manager of managers approach to venture out and get more experience with direct hiring,” says Jones. “They will typically allocate $ 100 million or $ 200 million and have five to 12 managers depending on the size of the assets, which range from $50 million to $1 billion.”

Case Study: NYCRS

For the 12 percent of New York City Retirement System’s (NYCRS) pension fund invested with emerging managers, most is done via funds of funds, largely because it helps with risk monitoring and back office operations. In making that decision, NYCRS weighs the added fund of funds fees against the compensation cost of internal staffing. “We ask ourselves, ‘Will we still make excess returns after fees?’ We consider that additive,” says Joseph Haslip, NYCRS’s Assistant Comptroller for Pensions. NYCRS has hired an internal person to oversee public markets but is using a fund of funds to hire emerging managers in private equity.

“In our view, you can hire emerging managers through fund of funds managers or directly,” adds Haslip. “The difference is one of whether these talented investors are in need of the support service that a fund of fund gives, such as compliance, reporting and back office support,” he says. “The reason you pay the fees in the fund of funds is that you know the underlying managers are benefiting from the services.”

NYCRS uses a fund of funds approach for its private equity emerging manager program, because like most pension plans and consultants, it is unfamiliar with the universe of small firms. The program currently looks at investments of $ 200 million or less, though the fund is proposing to change the threshold and raise the number to between  $ 300 million to $ 400 million. “That is a good size and more in line with our peers’ definition of $ 500 million,” says Haslip. NYCRS is also looking to expand its private equity emerging manager program, and will take it to the board to discuss it in May or June.

NYCRS is likewise using a managers of managers approach for its emerging public markets investments. It inherited Progress and FIS from the previous administration, and is in the process of adding three additional managers of managers to help deploy capital to managers with $1 billion or less. NYCRS has also hired emerging public markets managers directly when it has felt confident that they had the necessary back office and experience to execute. These are generally in the $ 1 billion to $ 5 billion range of AUM. ”There has been a high concentration in multi-billion dollar firms, but they all had zero AUM when they started,” says Haslip. He believes that firms that have accumulated $ 5 billion in assets can get on consultants’ radar, and can compete in most pension searches, but that there hasn’t been a graduation process for emerging managers of $1 billion, who have built adequate risk management systems to handle a direct relationship. NYCRS will look at managers in this category and help them grow. However, they must have good returns to qualify.

Still, unlike some plans sponsors, Haslip says that NYCRS doesn’t take an equity stake in their investment managers. “We are concerned about a potential double risk, if you have an equity stake in a manager and have to deal with a performance problem.”

Case Study: LACERS

LACERS hired three fund of funds of emerging managers for domestic equities, allocating $100 million to an aggregate of 17 managers. It has another fund of funds dedicated to private equity, and retains separate account mandates with minority managers.

“The criteria we use to determine whether a manager appears capable of managing institutional money vary by asset class and by mandate,” notes Robert Aguallo Jr., LACERS’s General Manager. The three fund of funds managers chosen by LACERS for the domestic equity portfolios are Attucks, Capital Prospects and Progress Investments, (see sidebar for submanagers). Among the groups represented, seven are African-American, five Hispanic and three Asian; one is Native American and one is woman-owned.  They hired Parish Capital Partners, a private equity fund of funds, for a $10 million buyout.

LACERS has long been an advocate of promoting the hiring of women and minority managers, encouraging them to apply to Request for Proposals (RFPs) for all of its manager searches. In 1993, LACERS hired its first minority-owned investment management firms for its active and passive domestic equity, and fixed-income programs.  In 2004, it broadened inclusion to the real estate and private equity asset classes. (See side bar.)

It also has a strong interest in promoting ethnic diversity among its vendors as well, adopting a policy encouraging the use of minority- and woman-owned brokerage firms. “The program is designed to enlarge the landscape of providers, increase broker competition, and access new trading strategies and firms,” says Aguallo.  In 2005, LACERS hosted a forum to bring together the minority-owned brokerage community and the pension fund’s publicly traded equity and fixed-income managers, in an effort to facilitate an increase in business. LACERS hired Consultiva, a woman-owned consultant firm to develop its emerging broker database. “We’re proactive in engaging consultants to ‘walk the talk,’” he says.