According to Donald A. Steinbrugge, a Managing Partner at hedge fund consulting and marketing firm Agecroft Partners, one prevailing trend is that large managers still have an advantage over their smaller competitors.

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Hedge Funds

Hedge funds an alternative to fixed income

“One trend that has been fairly consistent since 2008 is that money continues to flow to the largest managers,” Steinbrugge told StreetID. “A huge driver of that is that pension funds are continuing to increase their allocation to hedge funds. The reason they’re doing that is because most pension funds today view hedge funds as an alternative to fixed income.”

When pensions look at the potential returns they could receive from fixed income managers, they expect to receive a three percent return going forward. Hedge funds are targeting four to six percent.

Hedge funds’ returns are expected to be higher

“As long as hedge funds’ returns are expected to be higher than fixed income, you will continue to see more and more money going into hedge funds,” said Steinbrugge.

“The end result of more and more money flowing to managers with the strongest brand — it’s tougher for smaller funds to raise money, and smaller funds need to make sure that they excel. If they don’t, they’re gonna have a very difficult time raising money.”

With more than 10,000 hedge funds to choose from, investors have more than enough options. In order to succeed, Steinbrugge said that a fund must be strong in three key areas, starting with the product.

“When I say a strong product, people use multiple valuation factors to evaluate a hedge fund,” Steinbrugge explained. “They look at the organization, they look at the investment team and what their pedigrees are, they analyze the investment philosophy and process and try to determine what inefficiency the hedge fund is going after and what their advantage is in capturing that inefficiency to generate high returns.

“They look at risk controls. They look at who the service providers are — what the operational infrastructure of a firm is. Last but not least they look at track record. And track record tends to be…a bar you have to go over, and once you go over that bar performance-wise (relative to your peer group), then all of the other factors become equally important.”

Steinbrugge said that it is not necessarily the managers with the highest returns that are getting the most money, however.

“The ones getting the money are the ones that have very good returns but they also rank very well across the other evaluation factors,” he said.

Second, Steinbrugge said that funds need to be able to “articulate well what your differential advantages are across each of those valuation factors.”

“There’s a lot of good hedge funds out there that have all the building blocks to be successful but they can’t articulate what they do,” Steinbrugge added. “As a result, people’s perceptions of hedge funds are below reality.”

The third key factor has to do with distribution.

“That’s a combination of breadth and depth,” said Steinbrugge.

By “breadth,” Steinbrugge said that it is “being able to meet with a lot of investors that are qualified, and once you meet, having a tailored process to move them along the decision making process.”

It is important to not be too pushy, Steinbrugge said. But he also advises against being too passive.