One of the surest signs that the role of the hedge fund industry has changed since the financial crisis was that inflows continued throughout and following the 2013 equity bull market that left most hedge funds in the dust. Having seen traditional 60/40 portfolios fall apart during the crisis has caused institutional investors to value more than just returns.

By 2018, Citi expects hedge funds to have more than $4.8 trillion global assets under management, 80% more than the end of last year, but the mix of investors and the role that hedge funds play in their portfolios will continue to evolve.

“The majority of changes occurring in the hedge fund industry in the five years since the Global Financial Crisis (GFC) have stemmed from the emergence of risk-averse institutional investors as the dominant source of capital,” says a recent Citi white paper, Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization.

The growing importance of institutional investors

Before the crisis, the majority of hedge fund capital came from family offices and high net worth individuals, but those funds dried up more quickly and have only gradually increased in the years since, while institutional investors have been coming to hedge funds in droves.

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Part of the reason for this trend is that instead of simply thinking about exposure to hedge funds as if it were a monolithic asset class and then selecting managers, institutional investors now divide hedge funds into categories depending on directionality, liquidity and other factors. This means that there is more opportunity for hedge funds with different strategies to solicit investments from the same organizations, but it also means that due diligence has increased in scope and importance in recent years.

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Distinct hedge funds tiers appealing different market segments

As the hedge fund industry becomes larger, Citi also expects to see more distinct tiers of hedge funds catering to different types of clients. Boutique hedge funds in the $1 billion AUM range who are willing to build advisory relationships with clients have a better chance of picking up allocations from pension allocators. The world’s largest hedge funds, sometimes called asset gatherers by critics, differentiate themselves with bet-in-class platforms, risk and portfolio reporting, and a deep roster of trading talent to appeal to large pensions and sovereign wealth funds.

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But these large hedge funds are often organized around a single, well-known fund manager, and Citi predicts that their investment teams will be the breeding ground for the next generation of hedge fund managers, much like the famous Tiger Cubs that came out of Julian Robertson’s Tiger Management Corp.

“These individuals are typically exiting with the full support of and oftentimes a capital stake from their former employers and have large amounts of personal wealth to use to establish their own firms. They are launching near or even above the $1.0 billion AUM institutional threshold and the rush to lock in capacity with these emerging organizations is reminiscent not of the post-GFC capital-raising environment, but of the pre-crisis years,” says the Citi report.

The rate of hedge fund launches to liquidations has been falling since 2002 and has remained low since the financial crisis, but it could start to pick up again in the next few years.

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Growing retail exposure through alternative mutual funds

The final trend that Citi predicts will change the audience for hedge fund managers doesn’t actually involve hedge funds themselves. 40 Act alternative mutual funds run by traditional hedge fund managers have been gaining traction. Considering the similarities between hedge fund growth from 1990 to 1998 and alt mutual fund growth from 2006 to now, Citi thinks that alt mutual funds could see AUM double in the next five years.

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The full report from Citigroup can be found here