Top Hedge Fund Industry Trends

Hedge Fund trends and predictions for the year

• One of the Hedge fund trends is that assets under management will grow for the 11th time in 12 years.

• Overall revenue will decline slightly due to lower average fees for the industry.

• Most of the growth of the industry will benefit only the top 5% of hedge fund firms based on investors’ perceived quality. This will result in an increasing number of fund closures and, combined with fewer start-ups, a reduction of the overall number of hedge funds.

By Donald A. Steinbrugge, CFA, Founder and CEO Agecroft Partners, LLC

Each year, Agecroft Partners predicts the top hedge fund industry trends through their contact with more than 2,000 institutional investors and hundreds of hedge fund organizations. The hedge fund industry is dynamic and both managers and investors can benefit from anticipating, and preparing for, the changes likely to occur. Firms that can effectively evolve with the industry improve their chances of success while stagnant firms do so at their own peril. Below are Agecroft’s predictions for the Hedge Fund trends in the industry for the year.

Hedge fund industry assets to reach new all-time high

Despite the plethora of negative articles about the hedge fund industry, hedge fund assets have reached an all-time high in 10 of the last 11 years. There is clearly a disconnect between the mainstream media’s coverage of the industry and the reasons driving investors to continue to allocate to hedge funds. Across the hedge fund investor landscape, we see an improvement in sentiment towards the industry. As net redemptions from hedge funds decline, we forecast industry assets to grow by 3.0% over the next 12 months stemming primarily from hedge fund performance. Although we expect an overall increase in assets, it will not be enough to offset declining fees, causing overall revenue to decline.

Reduction of expected returns for a diversified hedge fund portfolio

Hedge fund performance is driven by a combination of alpha (manager skill) and beta (market driven return). The fixed income and equity markets experienced strong bull markets for the past 11 years and beta has been a tail wind for hedge fund performance – rewarding managers with net long market exposure. Still, over this period, investors’ return expectations for managers have steadily declined. Expectations of mid-teen returns in 2009, dropped to just above 10% in 2014 and down to mid-to-high single digits today.

As we begin the new year with historically low interest rates and equity markets near peak levels, investors anticipate beta and carried interest to contribute less to fund performance over the next few years thereby reducing the overall expected returns from hedge funds.  This reduction in expected return from beta may lead to hedge funds taking market-share from long only managers as well as change the relative demand for various hedge fund strategies.

Large rotation of assets based on changes in strategy preferences and relative performance of individual managers

While the past few years have been challenging for the performance of hedge fund indices, we have seen large dispersions of performance both across strategies and among managers within strategies. Underperforming managers will experience above average redemptions as investors grow increasingly impatient with disappointing performance from what they perceive to be high priced investment structures. Some of these assets will be reinvested with better performing managers in the same strategy. However, we expect most will flow into other strategies within the hedge fund industry as investors reposition their portfolios emphasizing active managers they believe will have more opportunity to add value.

Strategies that will gain assets include:

· Commodity Trading Advisors (CTAs). CTAs have historically had low correlation to the capital markets and performed well in 2019.  Investors will increase their allocation to CTAs in order to reduce tail risk across their portfolio.

· Specialty long/short equity – Managers perceived to have an information advantage or focus on less efficient areas of the market will see inflows.  These could include managers that focus on small cap stocks, emerging markets (e.g. China) and specific sectors (e.g. healthcare).  In addition, broad valuation differences and fundamentals are expected to impact equity returns more meaningfully in 2020 allowing more active managers to outperform.

· Relative value fixed income – Strategies that provide liquidity to complex/less-liquid fixed income securities have replaced bank proprietary trading desks. Skilled managers generate most of their return through alpha and actively hedge market risk.

· Strategies that blur the lines between private equity and hedge funds – Most of these are private lending/specialty financing and reinsurance.  These financing strategies do offer an attractive alternative to traditional fixed income, though there is growing concern about how they will perform in a market downturn.

Hedge Fund Strategies

Pension funds will increase allocations to hedge funds due to low interest rates

Most public pension funds have an actuarial rate of return assumption around 7.5%.  With interest rates and credit spreads near historic lows, pension funds will look to hedge funds to enhance returns in two ways. Many will either allocate some assets away from fixed income into to a diversified portfolio of uncorrelated hedge fund strategies or by viewing hedge funds as a ”best in breed” manager and allocating part of their fixed income allocation to hedge fund strategies such as, distressed debit, specialty financing, structured credit, relative value fixed income among other strategies. With the yield on the aggregate bond index in the mid- 2% range, the bar is low for hedge funds to add value on a risk adjusted return basis.

Investors changing views on how to research investment opportunities from fund structure to asset class

Ten years ago, most institutional investors divided their team’s research responsibilities by fund structure. If an investment firm had a traditional long only fixed income strategy they would call on the fixed income team. If this same firm created a high yield hedge fund they would call on the hedge fund team and if they created a private equity structure fund to invest in less liquid fixed income securities they would call on the private equity team. Today more and more institutions are using the “endowment model” approach and dividing up research by assets class. Some have an absolute return allocation, but this only includes hedge fund strategies with low correlations to the capital markets. All other hedge fund strategies are researched by the appropriate asset class team. This approach blurs the line between hedge funds and private equity and allows the investor to better align the fund structure with the liquidity profile of the underlying securities.

UK hedge funds, the second largest market in the world, will have greater focus on North America due to Brexit

The European Union was created to provide free trade among its members. In so doing, it also put non-EU members at a disadvantage. This was certainly true in the hedge fund industry where non-EU firms face high hurdles to comply with AIFMD, the EU’s regulatory framework. With the UK leaving the EU we expect UK hedge fund firms to focus more on North American investors and significantly less on those in continental Europe.

Evolving organizational structures for hedge fund organizations

Rising costs of operating a hedge fund business with shrinking fees will continue to impact the business model for many hedge fund organizations. Small and medium size hedge funds are increasingly outsourcing many parts of their business infrastructure as well as some research and investment related activities.  This includes, technology, analytics, legal, accounting, data services, compliance, marketing and sales. These outsourced providers can offer greater expertise in a more cost effective manner while reducing fixed costs to the fund manager.  We expect outsourcing to lead to the reduction in full time staff at small and medium sized hedge funds. Large firms that have built out substantial infrastructures will look to leverage these resources and diversify their firm revenue by either acquiring competitors or lifting out investments teams.

Quality marketing is essential for asset growth

The hedge fund industry is highly competitive with our estimate of 15,000 hedge funds in the market place. In 2020, we will have continued concentration of hedge fund flows into a small percentage of managers. We expect 5% of funds to attract 80% to 90% of net assets within the industry. In order to succeed it is not enough to have a high quality product offering with a strong track record. Performance ranking among the top 10% of hedge funds puts a manager in an exclusive group of 1,500 funds.  Hedge funds with high quality product offerings must also have a best-in-breed sales and marketing strategy that deeply penetrates the market and builds a high quality brand. This requires a team of well-seasoned professionals that will project a positive image of the firm. This can be achieved by either building out an internal sales team, leveraging a leading third party marketing firm, or a combination of both. We expect the industry to continue to consolidate with less new hedge fund startups and more hedge fund closing. Firms that do not have a high quality sales and marketing strategy will have a difficult time raising assets and have a higher probability of shutting down.

Continued growth of advisory business models

An increasing number of consultants, advisors, multi-family offices, funds of funds and Outsourced CIO’s are moving away from co-mingling client assets into a fund. Instead, they are adopting an advisory structure with bespoke portfolios of direct fund investments for each client. This is broadening the investor base of the hedge fund industry. Most client service will remain focused on the advising entity.  Still, this shift will cause hedge funds to bear the additional administrative costs of handling multiple accounts versus one comingled entity. To accommodate and attract this growing part of the market, hedge funds must respond to the unique needs of the advising entities. This includes flexibility with regard to account minimums and applying fee breaks based on cumulative assets originating from a single advisor.

Hedge fund performance since 1990. Source: CNBC

Almost no adoption of new CFA hedge fund performance standards

We strongly support the CFA Institute’s effort to create and implement performance standards in the hedge fund industry and believe  it is the right organization to lead this charge. Unfortunately, the new performance standards for the hedge fund industry have failed to address some of the most important issues regarding hedge fund performance reporting. We expect there to be limited acceptance of the new standards until they are redrafted.