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(HedgeCo.Net) The hedge fund industry is dynamic, and participants are best served by anticipating, rather than reacting to, change. Informed by our contact with more than two thousand institutional investors and hundreds of hedge fund organizations, the following is Agecrofts 10th annual list of top trends that we anticipate for the year ahead.
The good news for the hedge fund industry is that we have seen very few wholesale departures by hedge fund investors. However, we do expect very slow growth for the industry as it approaches a saturation point with over $3 trillion in assets under management. Total assets invested in hedge funds has reached peak levels in each of the past 9 years. Most of the growth in recent years has come from performance, with only a modest amount of new capital coming into the space. Most hedge fund investors still believe they can achieve diversification benefits from investing in hedge funds, which can also enhance the overall returns of a diversified portfolio. Although we expect industry assets to remain fairly stable, we anticipate instability at the strategy and manager level; most new assets invested in hedge fund managers are reallocations of capital redeemed from other managers.
Continued Broadening of the definition of Hedge Fund
The narrow definition of a hedge fund is an evergreen fund structure that charges a performance fee. As the market has reached a saturation point with institutional investors representing a majority of assets, large hedge fund organizations have evolved their business strategy. They have broadened the target markets from which they would like to raise assets, as well as the types of fund structures and strategies they are offering to best align with those investors interests. The definition of a hedge fund has expanded to include the broader offerings of an investment firm with traditional hedge fund expertise. When reporting their hedge fund assets, many firms today include not only the assets of their traditional hedge fund structures but also: separately managed accounts, co investments, UCITS, private equity funds, flat fee commingled vehicles, and 40ACT funds. The largest organizations in the industry are evolving their businesses into broader alternative investment strategies and structures. In time, there will be a blurring of the lines between alternative investments and traditional asset management firms.
Shift in demand away from long beta strategies and towards strategies with lower correlation to the capital markets
From the fourth quarter of 2016 through January of 2018 investor interest was heavily weighted toward strategies that had the potential to generate the highest returns. Februarys spike in volatility gave investors pause and they began to rethink their allocations to various hedge fund strategies. The continued rise of interest rates in the US, trade war tensions, and a fourth quarter sell off in the equity markets has shifted some investors focus from maximizing returns to protecting capital. We expect to see outflows from strategies with large exposures to market beta, and increased demand for strategies not highly correlated to the capital markets.
Structural changes within the long/short equity sector
The shift to risk-off mode will cause assets to flow out of the long/short equity sector, which has typically represented about a third of the industry. As mentioned in the previous trend, funds with long net exposures will likely see outflows. Among those, funds that will be particularly hard hit will be those that focus primarily on large cap stocks in developed markets. Many investors believe that the large cap equity market has become so efficiently priced that it is difficult to gain an information advantage. Areas within long/short equity that should see an increase in demand are those managers that focus on small and mid-cap stocks that are less followed by Wall Street, companies based in Asia, and sector specialists such as those that focus on technology or healthcare.
Record number of established hedge funds shutting down
The hedge fund industry is highly competitive with approximately 15,000 funds. Fund managers are constantly seeking improvements to gain a differential advantage over their competitors in identifying and capturing inefficiencies in the marketplace. We have seen many prominent hedge fund managers with strong brand names and long, successful track records, experience poor performance over the past few years. It is unlikely that institutions will give these brand name managers the leeway they once would. The industry is so competitive today that managers resting on the laurels of previous years will struggle to retain assets. The increase in volatility in the capital markets in 2018 will magnify the dispersion in performance among managers in similar strategies and accelerate redemptions for the underperformers. Many of these celebrity managers will need to reinvent themselves in this arms race for alpha. Those who dont should prepare themselves for outflows which could eventually result in the fund either closing or converting to a family office.
An increasing number of consultants, advisors, multi-family offices, funds of funds and Outsourced CIOs are moving away from co-mingling client assets into one fund. They are adopting an advisory structure with bespoke portfolios for each client who will invest directly into a hedge fund. Although most of the client service for these accounts will be focused on the advising entity, this shift will cause hedge funds to bear the additional administrative costs of handling multiple accounts versus one comingled entity. In order to attract this growing part of the market, hedge funds must respond to the unique needs of the advising entities. This includes being flexible on account minimums and applying fee breaks based on cumulative assets across all accounts where applicable.
More hedge funds offering co-investment opportunities to investors
Investors are often drawn to co-investment opportunities because they frequently include the best ideas of the fund, securities with less liquidity but greater return potential, and lower fees. When compared to an LP investment in a hedge fund, managers typically find the costs of administering co-investments higher and revenues lower. Still, co-investments are a way for hedge fund managers to potentially participate in certain investments they might not otherwise have sufficient capital to access while adding to their assets under management and generating incremental revenue.
Continued growth of applying hurdles for performance fees
There has been significant fee pressure within the hedge fund industry over the past few years. A majority of this fee pressure has been focused on the management fee, as most investors do not mind paying for performance. Investors are increasingly seeking to differentiate between performances driven by alpha versus beta. As a result, we are seeing a growing use of hurdles for performance, which vary from the risk free rate to performance above an index for long biased managers.
Historically, investors have focused very little on the overall expense ratio or which expenses the hedge fund has charged to the fund. There is no clear market standard as to which expenses are allocated to hedge funds and which are borne by the management company. Some managers have been more aggressive than others in allocating expenses to the fund. Recent changes to the U.S. tax code, limiting the deductibility of fund expenses for taxable investors, will create significantly more focus on this issue. As investors and their advisors begin to address 2018 taxes, they will realize the extent to which these expenses are impacting net returns. Towards the second half of 2019, we anticipate more investors will ask for information on funds expense ratios and disclosure on the expenses being allocated to the fund. Over time we expect this will either reduce the expense allocation or increase the number of hedge fund managers applying a cap on fund expenses.
Just as technology is being used to improve the investment process, it is also being applied to improving client service. Hedge fund managers are making more information available in an increasingly accessible way. Fund managers will use webinar technology to a greater extent for their quarterly and annual investor reviews, educational sessions, and prospect meetings. Although not quite as effective as face to face meetings, video webinars can offer an element of communication and understanding gained through human interaction that can be easily lost via email or phone.
2018 saw broad based decline in Asian markets and a reduction in the demand for Asia focused managers. We remain sensitive to the political landscape and the potential near term impact of trade policies by the US, China and other prominent global trading partners. Nonetheless, we believe that this declining trend will reverse, and that the reversal will be one of the strongest trends over the next decade.
We expect growth from both the investor side and the hedge fund side. Last year, the International Monetary Fund reported that two thirds of world economic growth over the next 5 years will come from Asia. At the same time, valuations of equities on a number of Asian markets trade significantly below valuation levels of European and U.S. markets. Many of the Asian markets are dominated by retail investors creating pricing inefficiencies that are ripe to be captured by hedge fund managers. With the growing Asian markets, we are seeing an enormous expansion of wealth that will be looking for investment ideas to deploy their capital. For many U.S. based hedge fund managers, their global marketing strategy has been primarily focused on Canada, Switzerland and the UK. Over the next decade this will expand drastically to include Singapore, Hong Kong, Japan, Australia, and Korea among other countries.
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