Why Emerging Managers Are the Key to Portfolio Diversification and Consistent Returns
In today's crowded investment landscape, finding managers who consistently deliver superior returns can feel like searching for a needle in a haystack. Many investors gravitate toward established managers with long track records, but an often-overlooked segment deserves your attention—emerging managers.
For investors looking to diversify their portfolios and capture consistent excess returns, investing in emerging managers can provide unique opportunities. Whether you're well-versed in alternative investments or exploring them for the first time, this guide offers insights into the benefits, risks, and strategies for identifying and working with emerging managers.
What Are Emerging Managers, and Why Are They Attractive?
Emerging managers are typically defined as fund managers who have been operating as a firm for less than five years and manage a relatively smaller asset base. Here’s why they’re worth considering:
Niche Market Focus: Emerging managers often specialize in niche markets that are overlooked by larger funds. These inefficiencies allow them to generate excess returns and diversification.
For example, Kirkland Capital Group (KCG), we are an emerging manager in the private credit space, focused on micro-balance commercial real estate loans. By specializing in this niche, we have consistently delivered double-digit returns since our fund’s inception while having low volatility of returns and low correlation to comparable public investments, all through capitalizing on opportunities that are passed on by larger firms..
Flexibility and Agility: Unlike established managers with bureaucratic constraints, emerging managers can swiftly adapt to changing market conditions. Their smaller size allows them to seize opportunities that larger funds often miss due to slower decision-making processes.
Aligned Interests: Many emerging managers invest their own capital alongside their clients, aligning their interests with those of investors.
At KCG, our alignment is particularly strong. The Carsley and Freeman families are the largest investors in the fund, demonstrating a deep personal commitment to the fund’s success. This means investors can trust that the fund’s financial well-being is tied directly to ours.
Lower Fees: Emerging managers typically have lower overhead and operational costs compared to established managers. This often translates to more competitive fees for investors, making the cost-benefit analysis favorable.
For instance, the Kirkland Income Fund has a management fee of only 1.5% on deployed capital only, without any additional performance, hidden, or profit-sharing fees.
“Emerging managers are typically defined as fund managers who have been operating as a firm for less than five years and manage a relatively smaller asset base.”
The Risks and Challenges of Investing in Emerging Managers
While emerging managers present exciting opportunities, they also come with inherent risks. Investors must understand these risks and take steps to mitigate them.
Lack of Track Record: One of the main challenges is the limited historical performance data available to evaluate emerging managers. Without a long-term track record, it’s harder to gauge their ability to deliver consistent returns.
However, at KCG, we offset this with our extensive experience in real estate, lending, and capital markets, including navigating numerous market cycles. By April 2025, we will have achieved five years of positive fund performance.
Operational Infrastructure: Emerging managers may lack the sophisticated systems and processes that larger firms have in place. This can create challenges in scaling operations and maintaining regulatory compliance.
At KCG, we effectively address this issue by utilizing our technology expertise, including leveraging AI, to develop efficient processes and systems that enable us to scale.
Capacity Constraints: Emerging managers may have a limited amount of capital under management and a small team, which can limit their ability to source, execute, and monitor a diversified portfolio of investments. They may also face challenges in raising additional capital and expanding their team as they grow.
Higher Volatility and Illiquidity: Emerging managers may invest in less liquid asset classes, which can reduce the ability to exit investments or exit at favorable prices. They may also have longer lock-up periods and redemption restrictions, which can reduce the liquidity and flexibility of the investors.
“While emerging managers present exciting opportunities, they also come with inherent risks.”
How to Identify and Evaluate Emerging Managers
Evaluating emerging managers requires a thoughtful approach, as their potential often lies in their unique strategies and niche expertise. Here’s how to approach this:
Clear Investment Thesis: A well-defined and compelling investment thesis is essential. The manager should demonstrate expertise in their niche and have a strong rationale for how they will generate returns.
At KCG, we only consider loans up to $1.2 million for the Kirkland Income Fund, which we call micro-balance commercial real estate bridge loans. We believe this sector is currently overlooked and lacks interest from both big and small lenders. This creates significant opportunities for us to outperform the market average. By concentrating on a market segment that bigger companies tend to ignore, we take advantage of market inefficiencies to consistently achieve superior results.
Disciplined Investment Process: The manager should have a structured, repeatable process for making investment decisions, with robust risk management protocols in place.
Sustainability of Competitive Edge: Investors need to understand what makes the emerging manager unique and whether that competitive edge is sustainable over time. This could include specialized networks, innovative strategies, or first-mover advantages in niche markets.
Operational Strength: Look for emerging managers who are committed to building their operational infrastructure. While they may not have the scale of larger firms, they should demonstrate a focus on compliance, reporting, and risk management.
At KCG, we have implemented strong internal controls and partnered with third-party fund administrators and auditors to ensure operational integrity and transparency.
References and Track Record: Although emerging managers may have shorter track records, it's still crucial to conduct thorough due diligence. Check references, verify performance data, and assess the manager’s reputation within the industry.
Get more information on this topic by watching our webinar on “How to Identify Market Inefficiency and Manager Edge”.
“Evaluating emerging managers requires a thoughtful approach, as their potential often lies in their unique strategies and niche expertise.”
How to Allocate and Monitor Emerging Managers
Once you’ve identified a promising emerging manager, the next step is to allocate and monitor your investment effectively:
Start Small: It’s often wise to begin with a smaller allocation and increase exposure as the manager proves their performance and potential.
Diversify: Spread your investments across different sectors, strategies, or geographies to mitigate the risk of concentrating too much capital in one emerging manager.
Ongoing Monitoring: Establish clear and frequent communication with the emerging manager. Request regular updates and reports, and make a habit of conducting periodic reviews of their performance, strategy, and operations.
At KCG, we provide monthly and quarterly investor updates and prioritize transparent communication with our investors to ensure they have a clear view of the fund’s performance.
Plan for Liquidity: Consider how the emerging manager's liquidity matches your own investment needs. It’s important to be prepared for longer lock-up periods, especially if the manager is investing in less liquid markets. Balancing this with more liquid assets can help manage overall portfolio liquidity.
“It’s often wise to begin with a smaller allocation and increase exposure as the manager proves their performance and potential.”
Why Emerging Managers Perform Well During Market Downturns
Investors often seek reassurance that their investments will hold up during market downturns. Emerging managers can excel during these periods due to their flexibility and niche focus. Because they are smaller and more agile, they can pivot quickly to reduce exposure in sectors facing headwinds and take advantage of undervalued opportunities.
For example, in past downturns, emerging managers in private credit have often been able to capitalize on market dislocations by offering alternative financing solutions when traditional lenders pulled back.
Conclusion
Emerging managers offer a powerful opportunity for investors to diversify their portfolios and capture untapped sources of return. With their focus on niche markets, flexibility, and alignment of interests, they provide a unique value proposition that can complement more traditional investments. But remember, investing in emerging managers also requires a thorough understanding of the risks, a solid due diligence process, and ongoing monitoring.
To get you started, download our free checklist, “10 Key Factors to Consider When Evaluating Emerging Managers”, to help you make more informed investment decisions.
