In 2019, recent U.S. tax law changes will focus investors’ attention as never before on hedge fund expenses. Boldface hedge fund managers, faced with intense competition, will have to reinvent themselves if they hope to stay in the game. And Asia, hit with market declines in 2018 and reduced demand for managers focused on the region, will reverse the trend over the coming decade.
These are among the predictions of Don Steinbrugge, head of Agecroft Partners, a third-party marketing firm that specializes in alternative investments with a particular focus on hedge funds. He has tapped the insights of more than 2,000 institutional investors and hundreds of hedge fund organizations for what to expect in the coming year.
Following are Steinbrugge’s predictions for the biggest trends in the hedge fund industry in 2019.
1. Hedge Fund Industry Reaches Maturity
Steinbrugge sees good news for the hedge fund industry in the fact that there have been few wholesale departures by investors. At the same time, he expects very slow growth as the industry approaches a saturation point with more than $3 trillion in assets under management, having reached peak levels in each of the past nine years. Performance has accounted for much of this growth in recent years, with only a modest amount of new capital coming into the space. Most hedge fund investors still believe they can achieve diversification benefits from investing in hedge funds, which can also enhance the overall returns of a diversified portfolio.
“Although we expect industry assets to remain fairly stable, we anticipate instability at the strategy and manager level; most new assets invested in hedge fund managers are reallocations of capital redeemed from other managers,” Steinbrugge writes.
2. Continued Broadening of the Definition of ‘Hedge Fund’
The narrow definition of a “hedge fund” as an evergreen fund structure that charges a performance fee has expanded to include the broader offerings of an investment firm with traditional hedge fund expertise, according to Steinbrugge. As the market has reached a saturation point with institutional investors representing a majority of assets, large hedge fund organizations have evolved their business strategy, broadening the target markets from which they seek to raise assets, and offering fund structures and strategies that best align with those investors’ interests.
When reporting their assets, many firms today include both the assets of their traditional hedge fund structures and those in separately managed accounts, co-investments, UCITS, private equity funds, flat fee commingled vehicles and ’40 Act funds. The biggest industry groups are evolving their businesses into broader alternative investment strategies and structures, eventually resulting in a blurring of the lines between alternative investments and traditional asset management firms.
3. Shift From Maximizing Returns to Protecting Capital
From the 2016 fourth quarter through January 2018, investor interest was heavily weighted toward strategies that had the potential to generate the highest returns. February’s spike in volatility gave investors pause, prompting them to rethink their allocations to various hedge fund strategies. The continued rise of U.S. interest rates, trade war tensions and the fourth-quarter selloff in the equity markets has shifted some investors’ focus from maximizing returns to protecting capital.
“We expect to see outflows from strategies with large exposures to market beta, and increased demand for strategies not highly correlated to the capital markets,” Steinbrugge writes.
4. Structural Changes Within the Long/Short Equity Sector
The shift to risk-off mode will cause assets to flow out of the long/short equity sector, which has typically represented about a third of the industry. Funds with long net exposures will likely see outflows, according to Steinbrugge. Particularly hard hit will be funds that focus primarily on large-cap stocks in developed markets. Many investors believe that the large-cap equity market has become so efficiently priced that it is difficult to gain an information advantage.
Areas within long/short equity that should see an increase in demand are those that focus on small- and mid-cap stocks that are less followed by Wall Street, companies based in Asia and sector specialists, such as those that focus on technology or health care.
5. Record Number of Established Hedge Funds Shutting Down
With some 15,000 funds, the hedge fund industry has become so competitive that managers resting on the laurels of previous years will struggle to retain assets. The increase in volatility in the capital markets in 2018 will magnify the dispersion in performance among those in similar strategies and accelerate redemptions for the underperformers, which have included celebrity managers. Many prominent managers with strong brand names and long, successful track records will need to reinvent themselves in the arms race for alpha. Those who do not should prepare themselves for outflows that could eventually result in the fund either closing or converting to a family office, as institutional investors are unlikely to give them the leeway they once did.
6. Growth of Advisory Business
According to Steinbrugge, an increasing number of consultants, advisors, multi-family offices, funds of funds and outsourced CIOs are moving away from commingling client assets into one fund, and adopting an advisory structure with portfolios customized for each client who will invest directly into a hedge fund. Although most of the client service for these accounts will be focused on the advising entity, this shift will burden hedge funds with the additional administrative costs of handling multiple accounts rather than just one commingled entity.
In order to attract this growing part of the market, hedge funds must respond to the unique needs of the advising entities, Steinbrugge says. This includes being flexible on account minimums and applying fee breaks based on cumulative assets across all accounts where applicable.
7. More Hedge Funds Offering Investors Co-investment Opportunities
Investors are often drawn to co-investment opportunities because they frequently include a fund’s “best ideas,” securities with less liquidity but greater return potential and lower fees. Compared to a limited partner investment in a hedge fund, managers typically find the costs of administering co-investments higher and revenues lower. Still, Steinbrugge notes, co-investments are a way for hedge fund managers to potentially participate in certain investments they might not otherwise have sufficient capital to access, at the same time adding to their asset base and generating incremental revenue.
8. Continued Growth of Applying Hurdles for Performance Fees
Fee pressure, which has been significant within the hedge fund industry in recent years, has been focused on the management fee, as most investors do not mind paying for performance, according to Steinbrugge. However, investors are increasingly differentiating between alpha-driven and beta-driven performance. A result is growing use of hurdles for performance, which vary from the risk-free rate to performance above an index for long-biased managers.
9. Greater Focus on Hedge Fund Expenses
Investors historically have not paid much attention to the overall expense ratio or which expenses the hedge fund has charged to the fund. No clear market standard exists for allocating expenses between hedge funds and the management firm, and some managers have been aggressive in allocating expenses to the fund, according to Steinbrugge. Watch for significantly more focus on this issue in light of recent changes to the U.S. tax code that limit the deductibility of fund expenses for taxable investors.
As investors and their advisors begin to address 2018 taxes, they will realize the extent to which these expenses are affecting net returns. “Toward the second half of 2019, we anticipate more investors will ask for information on funds’ expense ratios and disclosure on the expenses being allocated to the fund. Over time we expect this will either reduce the expense allocation or increase the number of hedge fund managers applying a cap on fund expenses.”
10. Enhanced Client Experience
Technology is being used to improve not only the investment process, but also client service. Hedge funds are making more information more accessible. Going forward, fund managers will use webinar technology to a greater extent for their quarterly and annual investor reviews, educational sessions and prospect meetings. Although video webinars are not quite as effective as face-to-face meetings, they can offer an element of communication and understanding gained through human interaction that can be easily lost via email or phone.
11. The Future Is Asia
Asian markets experienced broad-based decline in 2018, and demand for Asia-focused managers fell. “We remain sensitive to the political landscape and the potential near-term impact of trade policies by the U.S., China and other prominent global trading partners,” says Steinbrugge. “Nonetheless, we believe that this declining trend will reverse, and that the reversal will be one of the strongest trends over the next decade.”
He expects growth from both the investor and the hedge fund sides, noting that the International Monetary Fund reported last year that two-thirds of world economic growth over the next five years would come from Asia. At the same time, valuations of equities on several Asian markets trade significantly below valuation levels of European and U.S. markets. Many Asian markets are dominated by retail investors, creating pricing inefficiencies that are ripe for capture by hedge fund managers.
An enormous expansion of wealth is occurring in the growing Asian markets that will be looking for investment ideas to deploy their capital. Many U.S.-based hedge fund managers, whose global marketing strategy has been primarily focused on Canada, Switzerland and the U.K., will expand their horizons over the coming decade to the likes of Singapore, Hong Kong, Japan, Australia and Korea.