Hedge fund assets have hit record highs in each of the five past quarters, to some $3.2 trillion, and will grow by 5.5% over the next 12 months, according to Don Steinbrugge, head of Agecroft Partners, in his annual predictions of industry trends.
Assets have risen despite a drumbeat of bad news about hedge funds, Steinbrugge said. “There is clearly a disconnect between the mainstream media’s coverage of the industry and the reasons why investors continue to allocate to hedge funds. Across the hedge fund investor landscape, we see a significant improvement in sentiment towards the industry.”
Three brand-name hedge fund managers were recently sued by the Kentucky Retirement System for failure to deliver on their promises.
Steinbrugge said certain strategies and individual managers have performed well in recent years. Those that have not will see above-average withdrawals, with some of their assets reinvested with better performers in the same strategy. Most of those assets will flows into other strategies in which investors expect active managers to add value.
He said traditional long/short equity managers focused on developed markets and high-beta fixed income managers will likely lose assets.
These will gain assets, he said:
- Quant, which comprises multiple categories, is currently the strategy of seven of the 11 largest hedge fund firms
- Asia long/short equity: The IMF predicts that two-thirds of world growth will come from Asia over the next five years
- Reinsurance: The expectation of price hikes in 2018 has recently led to significant demand
- Higher turnover fixed income strategies that provide liquidity to complex/less liquid fixed income securities
- Strategies that blur the lines between private equity and hedge funds
Following are Steinbrugge’s predictions for the biggest trends in the hedge fund industry in 2018:
1. Arms Race for Alpha
The industry is experiencing an information arms race with respect to how much information can be gathered and how quickly it can be processed. Many managers are trying to bolster their decision making and improve traditional investment process by investing in new technologies, such as quantitative analytics, alternative data sources and artificial intelligence.
“Data scientist” has become a key position at many big firms, Steinbrugge said, responsible for amalgamating and leveraging information from web traffic, social media sentiment, online chat rooms, and GPS and satellite imagery to generate actionable forecasts on industries and companies.
2. Increase in Hedge Fund Closures
Steinbrugge said the industry remains oversaturated with some 15,000 funds, about 90% of which do not justify their fees, as evidenced by the mediocre returns of hedge fund indexes. Redemptions from underperforming managers will result in an increase in fund closures.
Both large established managers and emerging ones will feel the effects, he predicted. Some prominent managers’ strategies may no longer offer the alpha-generating opportunities that historically drove performance, while other large managers are simply too big to maintain an edge. Those with less than $100 million in assets — the majority of hedge funds — are being squeezed from both the expense and revenue sides of their businesses.
Size or fund tenure notwithstanding, poor performance will accelerate the outflows of capital and in some cases result in fund closures. Unfortunately, however, strong performance in a sustainable strategy will not suffice to generate inflows of capital. Hedge fund flows are increasingly driven by brand and distribution, which smaller hedge funds lack.
“We estimate only 2% of assets are flowing to these managers. As a result we expect the closure rate to continue to rise for small and mid-sized hedge funds.”
3. Pension Funds Evolving How They Use Hedge Funds
According to Steinbrugge, few pension funds have eliminated their hedge fund exposure because most believe these investment vehicles can enhance the risk-adjusted return of the overall portfolio. They generally continue to treat hedge funds as a separate asset class that offers low correlation to the equity and fixed income markets and expected returns of 4% to 6% that compare favorably to their fixed income portfolio.
More recently, some pension funds have adopted an “endowment model” approach to hedge fund investing. Rather than view them as an asset class, they are assessing the market exposure and risk profile of individual hedge fund strategies, and evaluating their potential to be a best-in-breed manager within the pensions’ overall allocation strategy. With this approach, they allocate hedge fund strategies to categories and measure them against tailored benchmarks that more accurately reflect their investment strategy and underlying securities rather than the fund structure. These buckets broadly include equities, fixed income and uncorrelated, though there is often further delineation.
“We believe this will have a long-term positive impact on pension fund portfolios and the hedge fund industry.”
4. Growth of Global Hedge Fund Distribution
Most U.S. hedge funds over the past five years have avoided the opaque, complex legal and regulatory requirements imposed by jurisdictions outside of the U.S., and focused their marketing efforts on the highly competitive domestic marketplace, where many investors are contacted by thousands of firms a year. Now, Steinbrugge expects growth in fund marketing outside the U.S., thanks to continued development by specialist law firms of products that identify and simplify the requirements of marketing in more than 100 countries around the world.
He noted that many of these countries have low or manageable barriers to entry, while others have potential benefits high enough to justify meeting certain reasonable requirements made clear by such products. In many of these jurisdictions, a large number of investors looking for high-quality hedge fund managers have been underserved.
Steinbrugge expects more hedge fund managers to use these products to either market directly to these lesser-known jurisdictions, if they can identify whom to call on or to hire third party marketing firms with established relationships to target specific regions or countries on their behalf.
5. Bullish on Cryptocurrency
At present, more than 120 hedge funds are focused on cryptocurrencies and blockchain technology, and Steinbrugge expects this number to increase two to three times in 2018. He says hedge funds will play a much larger role in the industry once correlations between cryptocurrencies and other industry players decouple and as futures markets are expanded to cryptocurrencies beyond Bitcoin.
He noted the importance of differentiating between the future growth of the industry and the current valuation of Bitcoin, whose current price has been bid up by hype and speculation. Unlike a bond that pays interest or an equity that generates earnings, the only thing supporting the value of Bitcoin is supply and demand, and the price volatility over recent weeks is evidence of the fragility of these markets.
Steinbrugge said the entire cryptocurrency market faces regulatory uncertainty as well as the risk of real loss from cyberattack, which would likely lead to a loss of investor confidence.
6. Increase in Outsourcing
According to Steinbrugge, the quantity and quality of hedge fund service providers has reached the level where hedge funds are increasingly outsourcing many parts of their business infrastructure as well as some research and investment related activities, including IT, legal, compliance, third-party marketing, back office, data providers and analytics.
“We expect full-time staffs of hedge fund to decline over time as more services are outsourced to companies with greater expertise that can provide services in a more cost-effective manner.”
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