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10 Hedge Fund Predictions for 2016

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In 2016, hedge fund investors’ return expectations will trend lower, while industry assets reach a new high, according to Donald Steinbrugge, founder and managing partner of Agecroft Partners.

In a highly competitive marketplace, Steinbrugge says, hedge funds will need a high-quality sales and marketing strategy in order to raise assets.

For the seventh consecutive year, Agecroft, a hedge fund and consulting firm, predicts industry trends through its contact with some 2,000 institutional investors and hundreds of hedge fund firms.

Following are Agecroft’s top 10 predictions for the biggest hedge fund industry trends in 2016.

Reduced Return expectations

1. Reduced Return Expectations

Hedge fund performance is driven by a combination of manager skill and market-driven returns — alpha and beta. From 2009 to the beginning of 2015, as both the fixed income and equity markets experienced strong bull markets, beta propelled hedge fund performance that rewarded managers with net long market exposure. Over this period, investors’ return expectations for new managers steadily declined from the mid-teens in 2009 to just above 10% in 2014 and to mid-to-high single digits today. Agecroft says these reduced return expectations stem mainly from many investors’ belief that beta will add very little value over the next few years as the capital markets trade near all-time highs.

Demand for Low-Correlation Strategies

2. Demand for Low-Correlation Strategies

Lower return expectations for hedge funds will strongly influence hedge fund strategy selection, according to Agecroft. Investors will perceive higher beta strategies as having higher—and unnecessary—risk. They will increasingly demand strategies such as relative value fixed income, market neutral long/short equity, CTAs, direct lending, volatility arbitrage, reinsurance and global macro, perceiving these as able to generate alpha regardless of market direction and as a hedge against a potential market sell-off.

Hedge Fund Assets to Reach All-Time High

3. Hedge Fund Assets to Reach All-Time High

Agecroft expects hedge fund industry assets to rise by $210 billion, or 7% (derived from a forecast of a 2% increase due to net positive asset flows and a 5% increase from performance), from an estimated $3 trillion today. It says this climb to a new all-time high will be fueled by pension funds reallocating assets out of long-only fixed income to enhance forward-looking return assumptions, and by other investors shifting some assets away from long-only equities to hedge against a potential market sell-off.

Smaller Managers Will Outperform

4. Smaller Managers Will Outperform

Smaller hedge funds, which often produce stronger performance than larger ones, should find the 2016 landscape particularly attractive, according to Agecroft. In moving to a performance environment increasingly dependent on alpha, security selection becomes ever more important, especially in less efficient markets where smaller managers have a distinct advantage over their bigger counterparts, many of which are past the optimal asset level to maximize returns for their investors. In addition, large fund managers, whose clients often are big pension funds run by risk-averse investment committees, have an incentive to reduce risk in their portfolios in order to maintain assets, and thereby increase the probability of continuing to collect large management fees.

Pension Funds Allocate to Smaller Managers 

5. Pension Funds Will Allocate to Smaller Managers

As pensions struggle to enhance returns to meet their actuarial assumptions, Agecroft says their hedge fund investment process has evolved to the point where 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 to have billions of dollars under management in order to be considered by pension funds, while today Agecroft estimates this has declined to $750 million and is expected to go lower over time.

Building the Brand

6. Building the Brand

Having a high-quality product offering with a strong track record will no longer ensure success in a marketplace awash in some 15,000 hedge funds. Agecroft predicts that in 2016, hedge fund assets will continue to flow into a small percentage of managers, with 5% of funds attracting 80% to 90% of net assets within the industry. To raise capital, hedge funds with robust product offerings must also have a best-in-breed sales and marketing strategy—and a top-flight team to execute it—that deeply penetrates the market and builds a high-quality brand. A firm can either build out an internal sales team, leverage a leading third-party marketing firm or do a combination of both.

Marketing Activity Outside the U.S.

7. Marketing Activity Outside the U.S.

Marketing activity outside of the U.S. has declined significantly over the past few years as AIFMD requirements have gone into effect within the eurozone. This has prompted a growing number of U.S.-domiciled funds to direct marketing efforts to U.S. investors, thus making the U.S. marketplace more competitive. Many non-U.S. firms are also targeting U.S. investors. Agecroft predicts this trend will reverse as hedge fund managers start to realize that investors outside the U.S. are significantly less covered, and that the registration burden of selling in many non-U.S. countries is less complex than they perceived. In addition, many Europe-based investors are willing to invest in smaller managers because of their higher return potential.

Relentless Pressure on Fees

8. Relentless Pressure on Fees

Pressure on hedge fund fees is coming from several directions. Institutional investors are successfully negotiating big reductions from standard fees for large mandates, and this is likely to increase as big institutions’ allocations represent a larger percentage of the market. Small hedge funds (generally those with less than $100 million under management) often have to offer a founders’ share class with a 25% to 50% discount to standard fees as an incentive to invest in their fund. Agecroft finds the “small fund” threshold is now trending up toward $200 million.

More Hedge Funds Shutting Down

9. More Hedge Funds Will Shut Down

Several factors indicate that hedge funds will shut down at an increased pace in 2016, according to Agecroft. With a near-record 15,000 funds currently in the market, the abundance of managers has reduced the average quality of hedge funds, and many lower-quality managers will close down, “which is good for the industry,” Agecroft says.

In addition, increased capital market volatility increases the divergence in overall return between good and bad managers, increasing the turnover of managers as bad ones get fired and money is reallocated to those that outperform.

And with the competitive landscape for small and midsize managers becoming increasingly difficult, these firms are being squeezed from both the expense and revenue side of their businesses. Having a superior quality product alone is not enough to generate inflows of capital. As a result, Agecroft expects the closure rate to rise for small and midsize hedge funds.

Blurring of the Hedge Fund/Private Equity Divide 

10. Blurring of the Hedge Fund/Private Equity Divide

In 2008, hedge funds and private equity funds differed mainly in their structure and less often in the liquidity of the underlying investments. This was especially true with illiquid fixed income instruments where many hedge funds that focused on these strategies offered monthly liquidity. This created significant liquidity mismatches for many hedge funds, causing them to impose gates, suspend redemptions or liquidate their fund. Today many sophisticated investors understand the benefits of illiquid investments, but demand fund liquidity provisions that match the underlying liquidity of the portfolio. Agecroft expects longer lockups, longer redemption notice periods, gates and private equity structures for illiquid strategies.