This year promises to be the best since 2007 for net flows into hedge funds, according predictions by Agecroft Partners, a global consulting and third-party marketing firm for hedge funds.
Donald Steinbrugge, Agecroft’s chairman, said in a statement released Tuesday that his firm had arrived at this conclusion after identifying several emerging trends in conversations with more than 300 hedge fund groups and 2,000 institutional investors last year.
1. Improved net capital flows across most major investor segments
- Pension funds will be the largest contributor to hedge fund sector growth in 2012 as they seek higher risk-adjusted returns to decrease their enormous unfunded liability.
- Endowments and foundations, which are structured to pay out only about 75% of their long-term expected earnings, will increase their assets by 10% to 20% annually, according to Agecroft projections, and hedge funds will grow along with them as many of the largest groups are fully allocated to the sector.
- Family offices will continue to be active allocators to hedge funds as an increasing number of ultra-affluent families hire full-time staff to manage their assets and these advisors become more knowledgeable about the sector.
- Funds of funds, staggered by redemptions for the past four years, albeit at a slowing pace, will continue to lose assets from large pension funds, which increasingly prefer to make direct investments in hedge funds to save on fees. However, these redemptions will be somewhat offset by smaller and mid-sized pension funds and insurance companies that are increasing their allocations to multimanager products and by high-net-worth individuals investing on the advice of their financial planners.
- Consultants have enjoyed tremendous growth as more institutional investors and big family offices have begun to invest directly in hedge funds. They are coming under increasing pressure from new players in the space, however, including traditional consultants and fund-of funds groups that offer customized separately managed portfolios to their large clients.
2. Rotation of assets among managers
In a very difficult 2011 for hedge funds, some managers effectively navigated the volatility to product creditable returns, creating a significant deviation in performance between managers with similar styles. Underperformers will suffer above-average redemptions, with most of those assets recirculating within the sector. Agecroft expects a continuing realignment of assets across all hedge fund strategies as investors strive to position their portfolios according to the economic environment.
3. Advantage to small and midsize hedge fund managers
Agecroft predicts that smaller, nimbler managers, a majority of the hedge fund sector, will gain momentum as some of the biggest, richest hedge funds were embarrassed by poor performance over the past year.
4. Strong brands attract asset inflows
Three hedge fund segments with resonant brand names will pick up the majority of net flows in 2012, according to Agecroft:
- Those with more than $5 billion in assets that have outpaced their peers in short- and long-term performance.
- A handful of high-profile startups that have spun out of proprietary trading desks at investment banks and well-known hedge fund organizations.
- Smaller funds that gain a competitive edge by providing a high-quality offering, articulating their advantages across the spectrum of evaluation criteria to investors and deploying a best-in-breed marketing strategy.
5. Rollouts and closures
Agecroft predicts that the three-year trend of hedge fund closures will turn around this year. Managers that badly underperformed their peers in 2011 and suffered heavy redemptions will have to close, but offsetting this will be the fourth consecutive year of increased launches.
6. Retail beckons
Many hedge fund managers are seeking assets in the less competitive retail market, according to Agecroft–UCITS funds burgeoned in Europe last year, and 40 Act hedge funds and funds of funds enjoyed growth in the U.S. Hedge fund replication strategies using ETFs also expanded.
7. Investor concentration risk
Agecroft said that many institutional investors rely almost completely on their consultants for advice about hiring and firing hedge fund managers, and consultants have amassed large amounts of assets. Some hedge funds have the majority of their assets controlled by just one or two consultants. Because the underlying investors are not making independent decisions, a sell order by just a few consultants could have strong negative implications:
- Risk to the hedge fund organization if its largest investor redeems.
- Possible imposition of gates or suspended redemptions.
- Risk to the makeup of the underlying portfolio after a large redemption: the potential for “toxic waste” when more liquid securities are liquidated to pay the redemption.
Read Outlook 2012 stories at AdvisorOne.com.