In the year ahead, look for smaller hedge funds to continue to outperform their larger counterparts and to increase net asset flows.
Funds of hedge funds, which have been hemorrhaging assets since 2008, will see more investors newly attracted to their expertise, thanks to the industry’s evolving fee structure that enables funds of funds no longer to charge double fees.
These are among the predictions for 2017 of Don Steinbrugge, founder and managing partner of Agecroft Partners, a third-party marketing firm that specializes in alternative investments with a particular focus on hedge funds.
Following are Steinbrugge’s top 10 hedge fund predictions for 2017.
1. Hedge Fund Fee Structures Evolve.
Steinbrugge predicts that hedge fund structures, under intense pressure by big institutional investors, will continue to evolve in order to attract and retain their mandates. He sees managers pursuing these three paths:
Some will base fees on allocation size, a standard practice in the long-only space, allowing them to avoid individual negotiations by reducing fees for larger allocations through a sliding scale fee schedule available to all investors.
Others will tailor fees for prospective institutional investors, whereby they will engage in give and take across management and performance fees, as well performance hurdles, performance crystallization time frames, longer lockups, guaranteed capacity agreements and potential revenue shares or ownership stakes in a management company in return for early-stage investments.
Many hedge funds are developing lower-fee strategies that can be used in a ‘40 Act structure, institutional share class or separate account. These structures are growing in popularity with large public funds focused on reducing fees, according to Steinbrugge.
2. Asset Outflows Continue.
Steinbrugge expects hedge fund redemptions by large institutional investors to continue in response to the drumbeat of pressure from union employees, politicians and the media. To address the concerns of their constituents, investment professionals of public pension funds will be required to more clearly communicate why they invest in hedge funds and how their performance should be evaluated.
Steinbrugge points out that many reasons exist for investing in hedge funds, among them reducing downside volatility, enhancing the risk adjusted returns of their portfolios or viewing hedge funds as best-in-breed managers. “Comparing hedge fund performance to that of equity markets is typically inappropriate,” he says.
3. Industry Assets Hit Another High.
Notwithstanding negative media coverage of the hedge fund industry and continued net redemptions from large institutional investors, Steinbrugge believes industry assets will reach an all-time high in 2017 — for the ninth consecutive year. He says this will be driven by a disconnect between the mainstream media’s coverage of the industry and the reasons why investors continue to allocate to hedge funds.
“We forecast redemptions of 3% of industry assets and average gains of 5%, resulting in a net increase of 2% of industry assets,” he says.
4. Increased Alpha.
President-elect,Donald Trump has promised — and tweeted about — many initiatives once he assumes the presidency, including plans to make major changes to the U.S. tax structure, infrastructure spending, international trade deals and health care spending. Steinbrugge says these changes will affect companies, sectors and markets differently, causing correlations to decline and volatility to increase closer to historical averages.
He notes that larger price movements provide more opportunities for skilled hedge fund managers to add value through security selection in strategies that capture greater price distortions in the market and accelerate performance as security prices more quickly reach price targets.
5. Large Rotation of Assets Among Managers.
The performance of hedge fund indexes has been challenged in recent years, but not all managers and strategies have performed poorly. There have been large dispersions of returns across strategies and among managers with similar styles. Underperforming managers will experience above-average withdrawals, forcing some to close down, with most of the assets recirculated within the industry. Some will be reinvested with better-performing managers in the same strategy. Most will flow into other strategies as investors reposition their portfolios based on capital market valuations and their economic forecasts.
Steinbrugge sees two major themes emerging for assets flows.
Capital markets valuations are hovering near all-time highs. Potential economic time bombs threaten: China relative to foreign reserves, a housing bubble and the banking system. Concern remains high regarding some of the weaker EU countries amid anemic global economic growth and little dry powder for global monetary authorities to stimulate economies. As a result, many investors are becoming increasingly concerned about downside volatility. In response, several strategies — relative value fixed income, market neutral long/short equity, commodity trading advisors, direct lending, volatility arbitrage and reinsurance — will continue to experience demand because of their perceived ability to generate alpha regardless of market direction and as a hedge against a market selloff.
Besides the strategies noted, this applies to long/short equity and fixed income trading oriented strategies. This is particularly good news for the long/short equity managers, many of which have recently experienced significant poor performance and outflows.
6. Smaller Managers Will Continue to Outperform.
For the year through November 2016, smaller funds significantly outperformed larger funds: the HFRI fund-weighted composite was up 4.5%, while the HFRI dollar-weighted composite was up only 1.9%.
Steinbrugge says a major issue within the industry has been the high concentration of flows to the biggest managers with the strongest brands: 69% of industry assets go to managers with more than $5 billion in assets under management. This has caused many of their assets to swell well past the optimal asset level to maximize returns for their investors. To retain assets, big managers also have an incentive to reduce the risk in their portfolio, which in turn lowers expected returns.
7. Increased Flows to Smaller Managers.
Despite studies that show younger and smaller funds perform better, firms with $5 billion or more control 69% of industry assets, up from 61% in 2009, according to HFR research. Steinbrugge says this trend will reverse because of institutional investors’ increased sophistication, poor recent performance by many brand-name funds, pressure on institutional investors to enhance returns and the belief that smaller, nimbler managers have an advantage in a performance environment increasingly dependent on security selection.
Steinbrugge says this is especially true for small managers operating in less efficient markets or capacity-constrained strategies. However, these flows will be concentrated in a very small percentage of managers, he says.
8. High Concentration of Net Flows to Strongest Brands.
The hedge fund market place is highly competitive. A typical institutional investor will be contacted by thousands of hedge funds a year, meet with around three to four hundred, have follow-up meetings with fifty and hire two, according to Steinbrugge.
He says most allocations will go to a small percentage of managers that fall into one of two categories. The first comprises the biggest managers with strong brands and distribution networks. The second includes small and midsize managers that excel at offering a high-quality investment product, clearly articulate their differential advantages among investors’ hedge fund selection factors and implement a distribution strategy that deeply penetrates the market.
9. More Hedge Funds Shutting Down.
Steinbrugge says with an estimated 15,000 funds in the industry, about 90% of all hedge funds do not justify their fees, which is evidenced by the mediocre returns of hedge fund indexes. Investors are increasingly more likely to redeem from underperforming managers, leading to an increase in fund closures.
He anticipates greater capital markets volatility, which will magnify the divergence in overall returns between good and bad managers and highlight underperforming ones. And notwithstanding their potential to outperform larger managers, the competitive landscape for smaller managers is increasingly difficult. They are being squeezed from both the expense and revenue sides of their businesses.
A superior quality product alone will not generate inflows of capital, Steinbrugge says. “Hedge fund flows are increasingly driven by brand and distribution, which these hedge funds lack. As a result, we expect the closure rate to continue to rise for small and mid-sized hedge funds.”
10. Positive Flows to Funds of Funds With Niche Expertise.
Funds of hedge funds have lost assets since 2008, a major criticism being the double layer of fees. Steinbrugge says now that a majority of hedge funds offer reduced fees for larger allocations, many funds of funds are no longer charging double fees because their fee is offset by a reduced fee structure from the funds in which they invest. The lower fee structure is competitive with what investors are paying for direct investments, and this makes the expertise funds of funds offer more compelling.
He says niche expertise that should experience growth includes funds of funds that focus on emerging managers, and strategies that require longer lockup vehicles to take advantage of inefficiencies in less liquid investments.
— Related on ThinkAdvisor: