South Africa’s pension fund industry is dominated by a handful of large, established managers: Ninety One, Old Mutual, Sanlam, and a few others control the majority of AUM. This concentration creates opportunity for emerging managers, smaller, newer firms willing to challenge incumbents through specialized expertise, innovative strategies, or superior service. For institutional investors, emerging managers offer the potential for outperformance, lower costs, and refreshed perspectives on market opportunities. However, emerging managers carry higher risk due to smaller asset bases, limited track records, and operational constraints. This article explores how to identify, evaluate, and allocate to emerging managers effectively.

Why Emerging Managers Matter: The Case for Emerging Manager Allocation

Academic research consistently demonstrates that newer, smaller asset managers often outperform incumbents during their early years. Several factors explain this: (1) hunger and motivation: emerging managers are incentivized to outperform to attract capital; (2) flexibility: smaller managers can adopt nimble strategies and adapt quickly to market changes; (3) focus: emerging managers often specialize in specific niches rather than covering all markets, allowing deeper expertise; (4) innovation: smaller managers are more willing to challenge conventional thinking and develop novel strategies.

Conversely, established managers face “performance drag” from scale: large AUM creates constraints (difficulty deploying capital in profitable smaller positions, reduced trading flexibility, organizational bureaucracy). This dynamic creates a “cycle of life” in asset management: emerging managers outperform, grow rapidly, eventually underperform as scale constraints emerge, and are subsequently displaced by newer emerging managers.

Savvy institutional investors exploit this cycle by allocating to emerging managers in early growth phases (when motivation is highest and scale hasn’t created constraints), capturing outperformance, then rotating to newly emerging managers as earlier picks mature. This requires active fund monitoring and tactical allocation management but can generate meaningful alpha.

Identifying Emerging Managers: Selection Criteria

Manager Specialization: The most successful emerging managers typically specialize in specific niches where they possess genuine expertise advantage. Examples include: (1) smaller-cap SA equity specialists (with deep company research and management relationships); (2) fixed income specialists focused on credit opportunities; (3) ESG/sustainability-focused managers; (4) emerging market specialists; (5) alternative strategy specialists. Generalist emerging managers competing across all asset classes face steeper competitive challenges.

Manager Team and Track Record: Evaluate the emerging manager’s team carefully. Were the key investment professionals successful at prior firms? If a successful analyst at a major manager leaves to establish an emerging firm, that signals credibility. Conversely, team members starting for the first time carry execution risk.

Emerging managers should have documented track records of their investment approach, even if fund track record is short. A manager establishing an emerging firm at age 45 with 20 years of investment experience is different from a 30-year-old with 5 years of experience. Seek managers with demonstrated investment track records at prior firms.

Investment Philosophy and Process: Evaluate the emerging manager’s investment philosophy rigorously. Is their approach based on sound investment principles and differentiated thinking? Or is it trendy, chasing recent market winners? Emerging managers should articulate clear investment philosophy, documented decision-making process, and conviction in their approach.

Business Model and Sustainability: Assess whether the emerging manager’s business model is viable. Do they have sufficient assets to support operations? Are they dependent on a single large client (concentration risk)? Have they demonstrated ability to raise capital and attract clients? Emerging managers with sustainable business models (diversified client base, growing AUM, reasonable fee structures) are preferable to those dependent on founder credibility or small client bases.

Evaluating Emerging Manager Risk

Operational Risk: Smaller emerging managers may lack robust operational infrastructure. Do they have adequate back-office support? Is reporting and compliance robust? Have they experienced operational issues or errors? Operational risk is particularly acute for emerging managers in their first 2-3 years.

Key-Person Risk: Emerging managers often depend heavily on founder/lead manager credibility. What happens if that person departs? Is there succession planning? Is the investment approach dependent on one individual’s genius, or is it replicable by the team? Funds with significant key-person risk merit caution.

Track Record Risk: Emerging managers typically have limited track records (3-5 years of actual fund performance). This creates uncertainty about whether historical performance reflects genuine skill or luck. Additionally, track records are typically from favorable market periods. How did the emerging manager perform during the last significant market drawdown? Limited stress-testing data increases risk.

Survivorship Risk: Many emerging managers fail within 5 years. Failure occurs due to underperformance, inability to raise assets, operational problems, or team conflicts. Investors in emerging managers accept non-trivial probability that the manager will underperform, fail to grow, or experience significant setbacks.

Optimal Emerging Manager Allocation Strategy

Given the risks and opportunities, emerging manager allocation should follow disciplined guidelines:

Size of Allocation: Allocate smaller amounts to emerging managers relative to established managers. If your portfolio allocates R100 million to established managers, emerging manager allocation should be 10-25% of that (R10-25 million), not equivalent amounts. This limits downside if emerging managers underperform or fail.

Number of Emerging Managers: Diversify across multiple emerging managers rather than concentrating in single managers. Allocating R10 million to one emerging manager concentrates risk; allocating R5 million to each of two emerging managers provides diversification benefits while limiting single-manager downside.

Holding Period: Commit to longer time horizons with emerging managers (5-7 years minimum) to allow their strategies time to mature and demonstrate consistency. Quickly switching allocations before strategies have sufficient time to prove themselves defeats the purpose and locks in losses during drawdown periods.

Selectivity and Due Diligence: Due diligence on emerging managers must be exceptionally rigorous. Take additional time to evaluate team, philosophy, and operational capabilities. Speak with existing clients (if the manager permits) and industry contacts to verify quality. Emerging manager selection requires more work than established manager selection.

Sectors and Strategies Where Emerging Managers Excel

SA Small-Cap Equities: Emerging managers focused on smaller-cap SA equities often outperform larger managers due to research depth and company relationship advantages. This is a sector where emerging managers frequently demonstrate alpha.

Fixed Income and Credit: Emerging fixed income specialists, particularly those focused on credit analysis and bond selection, often outperform large generalist managers. The fixed income sector rewards security-specific insight, which emerging specialists often possess.

ESG and Sustainability Investing: ESG-focused emerging managers are growing rapidly as institutional capital shifts toward sustainability. These managers often possess deep ESG expertise and conviction-based approaches that differentiate from established managers retrofitting ESG into traditional processes.

Specialist Alternatives: Emerging managers offering alternative strategies (hedge funds, long-short equity, event-driven) often compete effectively with larger managers by offering specialized expertise and nimble implementation.

Red Flags and Risks to Monitor

• Emerging managers claiming consistently high returns (15%+) without adequate risk management discussion, likely reflecting either luck or underreporting risk.

• Emerging managers with excessive fee structures relative to peers suggests either desperation for assets or unrealistic expectations about future returns.

• Emerging managers resistant to detailed due diligence or providing only marketing materials, legitimate managers welcome rigorous scrutiny.

• Emerging managers with high staff turnover or recent key departures signals internal challenges or instability.

• Emerging managers with single-client concentration or founder-dependent business models heightens sustainability risk.

Key Takeaways: Emerging Manager Strategy

• Emerging managers offer potential for outperformance due to focus, flexibility, and motivation but carry higher risk due to limited scale and track record.

• Allocate smaller amounts to emerging managers (10-25% of established manager allocation) to limit downside exposure.

• Seek emerging managers with specialized niches, documented prior track records, and robust business models.

• Conduct exceptionally rigorous due diligence on team, philosophy, operations, and sustainability before allocating capital.

• Diversify across multiple emerging managers rather than concentrating in single managers.

• Commit to longer holding periods (5-7 years minimum) to allow strategies time to mature and demonstrate consistency.

• Monitor emerging managers actively for performance, operational changes, or team departures that signal changing quality.