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Some Small Hedge Funds Reap Big Gains in Tough Times As volatility hurts many investing strategies, a few of the smallest funds are putting up some of the biggest returns

Hedge funds are trailing the U.S. stock market this year. Some of the smallest funds are emerging as some of the best performers, driving greater demand for these types of managers.

Funds with less than $1 billion in assets are benefiting from their more manageable portfolios. They can dart in and out of holdings to protect gains or minimize losses amid the market volatility that has characterized this year. They also get more bang for their buckmaking investments that require less firepower to affect their overall performance. Among little funds putting up big numbers: London-based Alanda Capital Management Ltd., which manages less than $500 million and gained about 53% through November. Founder Christian Vogel-Claussen said his funds competitive edge comes from having a concentrated portfolio built by data science and fundamental research. The portfolio, which includes technology and consumer holdings, typically comprises 15 bets that stocks will rise and the same number of wagers on stocks falling.

We want to be the nimble speedboat, Mr. Vogel-Claussen said.

That agility is in demand today. Some investors were too nervous between March and June to take chances on small funds they hadnt done due diligence on. But as they acclimated to Zoom and as lockdowns lifted, they became more confident, according to Murano, a firm that connects institutional investors with fund managers. Requests for boutique managers rose 22% in the third quarter from a year earlier.

Other outperformers include Accendo Capital, an activist investor with 140 million, equivalent to $170 million, in assets that targets Northern European companies. The firm, which returned 41% as of November, added more than 10 million in new assets this year, including from five new investors. Founder Henri sterlund said he wants the firm to stay around $500 million to keep the focus on performance and not on asset chasing.

Caygan Capital, which manages around $500 million from London and Singapore, returned nearly 40% through November in one of its funds. At the end of March it bought the debt of global banks and other financial institutions, said a person familiar with its performance, as central banks cut interest rates and acquired fixed-income securities to support the global economy.

A BlueBay Asset Management LLP credit strategy with $219 million in assets was up 21% through November, partially from trading the debt of U.S. and other auto makers, said senior portfolio manager Geraud Charpin. At the beginning of the year, he bet on prices falling because of the costly challenges in transitioning to electric and driverless cars. He cashed out of the bets at the end of March as the spread of the coronavirus sparked a markets selloff.

As the auto makers debt prices rebounded, Mr. Charpin began shorting the sectors credit in September because the industrys problems persist.

Many of these funds larger peersincluding some of the industrys best-known nameshave lost money this year, caught off guard by sudden market swings resulting from the pandemic.

Even for smaller funds, double-digit returns havent been the norm. As of Oct. 31, the most recent data available, funds with less than $250 million in assets returned 1.12%, according to research firm eVestment. That still put them ahead of the worlds 10 largest hedge funds, which were down 1.85%. Funds with more than $1 billion were down by 2%.

Over the same period, eVestments Hedge Fund Aggregate benchmark returned 0.74%, while the S&P 500 returned 2.77%. Including November, the S&P was up 14%.

Maria Kindness, co-founder of Impactus Partners, which raises capital for alternative investments, said investor queries for smaller managers have surged in recent months. She attributes that to many having single or specialist strategies.

The Galton investment team at New York-based Mariner Investment Group LLC manages $868 million for a strategy that focuses on securitized products, including agency mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. It returned around 22% as of October.In early March, Galton bet yields of mortgage-backed securities, or MBS, would rise as mortgage originations had jumped and spreads between the interest rates of MBS and Treasurys widened, said portfolio manager Adam Rilander. The money manager reversed course later that month, betting MBS prices had fallen too much and buyers would returna move that benefited from the Federal Reserves decision to buy MBS at the time. Both trades paid off.

Academic research from 2015 found that on average between 1995 and 2014, smaller hedge funds performed better during crises. A 2019 paper found that as funds get bigger, their income from management fees, which is based on the amount of assets they have, grows. That gives managers fewer incentives to improve performance.

Small funds have outpaced their bigger brethren for several years, but many investors have clung to the idea that big is better. Funds with more than $5 billion still control two-thirds of the industrys $3.3 trillion in assets, according to data researcher HFR.But their smaller counterparts are getting a second look. When Julien Sevaux, co-founder of London-based investment firm Eighteen48 Partners, was considering distressed strategies in March, he eschewed larger and more generalist distressed funds. He said he sought out smaller, specialist managers to deploy money faster and in a more focused way, putting money with a less-than-$1 billion fund focused on structured products including collateralized loan obligations.

Karl Rogers, a Dublin-based consultant who chooses hedge-fund investments for family offices, said investors typically like to see funds with a long track record. But he says he trusts emerging funds that had the resilience to weather the pandemic, the 2019 rally and 2018 volatility.

Now is a good time to get involved with these smaller managers, he said.