Agecroft Partners’ Top 10 Hedge Fund Industry Trends For 2016 by Donald A. Steinbrugge, CFA – Agecroft Partners
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 very dynamic and both managers and investors can benefit from anticipating, and preparing for, what changes are likely to occur. Those who effectively evolve with the industry will succeed, while stagnant firms will be left behind. Below are Agecroft’s predictions for the biggest trends in the hedge fund industry for 2016.
- 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). From 2009 to the beginning of last year, as both the fixed income and equity markets experienced strong bull markets, beta had been a tail wind for hedge fund performance that rewarded managers with net long market exposure. Over this time period, investors’ return expectations for new managers steadily declined from mid-teens back in 2009, to above 10% in 2014 and to mid-to-high single digits today. This reduction in expected returns stems mostly from the belief from many investors that beta will add very little value over the next few years due to the capital markets trading near all-time highs. This reduction of return expectations will have a broad impact throughout the hedge fund industry.
- Greater Demand for Hedge Fund Strategies with Low Correlations to Long Only Benchmarks. Lower return expectations for hedge funds will dramatically change the relative demand for hedge fund strategies. Higher beta strategies will be perceived as higher (and unnecessary) risk. Some of the strategies that will see a significant increase in demand include: relative value fixed income, market neutral long/short equity, CTAs, direct lending, volatility arbitrage, reinsurance and global macro. These strategies will see an increase in demand due to their perceived ability to generate alpha regardless of market direction and as a hedge against a potential market sell-off.
- Hedge Fund Industry Assets to Reach All Time High in 2016. Despite all the negative stories about the industry, including some recent high profile fund closures, total hedge fund industry assets will reach a new all-time high in 2016. This will be fueled by investors led by pension funds reallocating assets out of long only fixed income to enhance forward looking return assumptions and other investors shifting some assets away from long-only equities to hedge against a potential market sell-off. We expect hedge fund industry assets to rise by $210 billion, or 7%, which was derived from a forecast of a 2% increase due to net positive asset flows and a 5% increase from performance.
- Smaller managers will outperform. While many studies have shown stronger performance by younger and smaller funds, the 2016 landscape should provide a particularly attractive environment for smaller hedge funds. In moving to a performance environment increasingly dependent on alpha, security selection becomes even more important, especially in less efficient markets where smaller managers have a distinct advantage. Since 2009 there has been a high concentration of hedge fund investment flows to the largest managers with the strongest brands. This has caused many of these managers’ assets to swell well past the optimal asset level to maximize returns for their investors. As they become larger, it is increasingly difficult for large, multi-billion dollar funds to add value through security selection. Additionally, large fund managers are often stewards of capital for many large pension clients and thought of as ‘safe hands’ by risk adverse investment committees. They have an incentive to reduce risk in their portfolio in order to maintain assets and thereby increase the probability of continuing to collect large management fees.
- Pension funds reducing the average size of managers to whom they allocate. As pensions struggle to enhance returns to meet their actuarial assumptions, we will also see an increase in the speed of the evolution of pension funds’ hedge fund investment process. Historically, many pension plans started with an investment in hedge fund of funds, followed by hiring a hedge fund consultant and investing directly in, typically, the largest hedge funds with the strongest brands. As they increased their knowledge of the hedge fund industry and added to their internal research teams, they began making more independent decisions and focused on “alpha generators” which included mid-sized managers. Finally, they evolved into the “endowment fund model” or best-of-breed strategy of investing. In the final stage, hedge funds are no longer considered a separate asset class, but are incorporated throughout the pension fund’s portfolio. Five years ago a hedge fund typically needed multiple billion in AUM to be considered by pension funds, while today we estimate this has declined to $750 million and expected to go lower over time. This will have a very positive impact on the hedge fund industry.
- High quality marketing is essential for asset growth. The hedge fund industry is highly competitive with our estimate of over 15,000 hedge funds in the market place. In 2016, 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. Firms that do not have a high quality sales and marketing strategy will have a difficult time raising assets.
- Increased Hedge Fund Marketing Activity outside the US. Marketing activity outside of the US has declined significantly over the past few years due to AIFMD requirements becoming effective within the Euro-zone. This has increased the focus on marketing to US investors by a growing number of US domiciled hedge funds (with a majority of hedge funds already located in the US) which has caused the US market place to become increasingly more competitive. Additionally, many non-US firms aggressively target the US market. We believe this trend will reverse as managers begin to realize that hedge fund investors outside the US are significantly less covered and the fact that the registration burden of selling in many non-U.S. countries is less complex than perceived. In addition, a large segment of European based investors tend to be more willing to invest in smaller managers due to their higher return potential.
- Continued pressure on fees. The hedge fund industry is seeing pressure on hedge fund fees from many fronts. Large institutional investors are successfully negotiating large fee reductions from standard fees for large mandates and this pressure is expected to increase as large institutions represent a larger percentage of the market. Small hedge funds (generally those under one hundred million