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.