7 Years From Now: The Hedge Fund Industry

dubai3-hedgethink 7 Years From Now: The Hedge Fund Industry

The hedge fund is going through a period of unparalleled growth, with new money flowing into the industry from a new wave of tech billionaires, institutional investors looking to diversify away from long-only mutual fund strategies that leave them at the mercy of the markets, and new vehicles intended to make hedge fund strategies available to retail investors for the first time.

Many notable thought leaders within the industry – including Hedge Fund Group founder Richard Wilson – believe that this pattern of recent growth will continue for the forseeable future. In a recent newsletter, Wilson made the following predictions:

“7 years from now the hedge fund industry is going to double in assets under management, the number of funds will increase by 50% and the types of
investment strategies will become more diversified as well.”

Whether this will actually transpire or not, only time will tell. However there are several compelling reasons to believe that it might. Here is an overview of current trends in the hedge fund industry that could point towards a bright future for the industry:

Strong positive flows into the industry

The industry-wide increase in assets under management in recent years has been, to a large extent, driven by an influx of money from large institutional investors, such as pension funds, into the industry. We can expect this trend to continue for as long the forward looking return expectation for a diversified hedge fund portfolio continues to be higher than those expected for long only fixed income funds. The numbers for 2013 certainly seem to vindicate the decisions of those institutional investors who made the shift, with the average hedge fund being up approximately 8.5% as opposed to the 1.5% for the Barclays Aggregate Index, used as a benchmark by many pension funds for their fixed income portfolios.

Long/short equity the most in-demand hedge fund strategy

Before 2008, long/short equity represented over 40% of hedge fund industry assets. In the intervening years, this type of strategy experienced large out flows to others such as CTAs and fixed-income-oriented strategies, bottoming out at around 25% of industry assets at the outset of 2013. However, this trend reversed in 2013, and the demand for long/short equity has continued to grow this year. This is because many investors believe it to be the the strategy that is most likely to generate double-digit returns in the future, and if long/short equity managers’ short books start to generate consistent profits again we can expect an acceleration in this trend.

Big names growing fast

In recent times, much of the growth in terms of assets under management has occurred at an elite group of managers that have the strongest brands, and we can expect most of the asset flows to continue to go towards the biggest managers. However, there has been increasing evidence that the best small funds are outperforming their larger counterparts, and small- to mid-sized managers who can offer outsize returns and articulate their advantages clearly will continue to stand a strong chance of attracting capital going forward. This high concentration of asset flows will also continue to benefit the third-party marketing industry as competition among hedge funds for new capital hots up.

More hedge funds closing to new investors.

With more and more money flowing into funds managed by the best-performing managers, many of these managers have reached a point where they have surpassed their optimum asset capacity to maximize risk-adjusted returns. This has led to a shift in focus among some managers towards an asset-gathering approach aimed at collecting large management fees, rather than generating the maximum possible returns for investors in their funds. However, an increasing number of managers are taking a ‘small is beautiful’ approach and closing funds to new investors – or even returning funds – in order to keep assets within a sweet spot and maximise returns for investors at the expense of greater management fees.

Average hedge fund fees declining

Although there is little in the way of pressure on the fees paid by small and medium sized investors to hedge funds, large institutional investors seem to using their clout to reduce the fees charged to them, and we can expect this trend to continue as big institutional investors represent a larger and larger share of the market for hedge funds. The pressure on fees is also in evidence in other fund structures such as 40 Act funds, managed accounts, and UCITs structures.

Fund liquidity terms aligning with those of the underlying investments

Prior to 2008, fund liquidity terms were determined to a large extent by the terms demanded by fund-of-funds, which demanded monthly liquidity even in the case of illiquid strategies. However, in the current climate, large institutional investors with long time horizons are wielding far more in the way of influence over fund terms, and the upshot of this is that they are becoming more closely aligned with those of the underlying assets. For example, for liquid strategies such as long/short equity they are demanding monthly liquidity with no hard lock up, while for less liquid strategies, they prefer to see less frequent redemption periods, longer notice periods, and hard lock-ups in order to prevent other investors from making redemption demands that undermine the efficacy of the strategy.

40 Act funds to see rapid growth

With many new 40 Act single strategy hedge funds and funds of hedge funds entering the market, this is clearly seen to be a growth area for the industry. The earliest 40 Act funds were hugely successful in attracting investment, often with inferior products to the traditional hedge funds attracting institutional assets. However, it will become much more difficult to raise assets for these as competition increases.

Niche hedge fund of funds to see positive flows

With more and more pensions replicating the strategies of hedge fund of funds that follow strategies of diversified portfolios of the biggest hedge fund managers, these types of funds are expected to fall by the wayside in favour of fund of funds that excel in a particular niche, such as specific strategies, regions, or emerging managers.