In 2020, hedge fund industry assets under management will continue their decade-long growth. Most of that growth, however, will benefit only a tiny percentage of firms, with the result of fewer fund launches and more closures. And in the wake of Brexit, U.K. hedge fund managers will increasingly turn their attention to North American investors.
These are among the insights of some 2,000 institutional investors and hundreds of hedge firms, that Don Steinbrugge, head of Agecroft Partners, a third-party marketing firm that specializes in alternative investments, has tapped for his annual list of predictions of what lies ahead in 2020 for the hedge fund industry.
Here are Steinbrugge’s predictions for the biggest trends in the hedge fund industry in 2020.
- Hedge Fund Industry Assets Hit New Peak
Steinbrugge forecasts hedge fund industry assets to grow by 3% over the next 12 months, stemming mainly from performance — hedge fund assets hit all-time highs in the 10 of the last 11 years. However, he says, this will not offset declining fees, which cause reductions in overall revenue.
- Lower Returns for a Diversified Hedge Fund Portfolio
Hedge fund performance derives from a combination of manager skill (alpha) and market driven return (beta). As fixed income and equity markets experienced strong bull markets for the past 11 years, beta has been a tail wind for hedge fund performance, rewarding managers with net long market exposure. Even so, investors’ return expectations for managers have steadily declined over this period — from mid-teen returns in 2009 to mid-to-high single digits today. Now, with historically low interest rates and equity markets at near peak levels, investors anticipate beta and carried interest to contribute less to fund performance over the next few years, thereby reducing the overall expected returns from hedge funds. Steinbrugge says this reduction in expected return from beta may lead to hedge funds taking market share from long-only managers, and could alter relative demand for various hedge fund strategies.
- Large Rotation of Assets
During the past few years, hedge fund performance has been widely dispersed both across strategies and among managers within strategies. Steinbrugge expects underperforming managers to experience above-average redemptions by investors increasingly impatient with disappointing returns from what they perceive to be high priced investment structures. Some of these assets will be reinvested with better performing managers in the same strategy. But he expects most will flow into other strategies within the hedge fund industry as investors reposition their portfolios to emphasize active managers they believe will have more opportunity to add value.
- Strategies That Will Gain Assets
Commodity trading advisors. These have historically had low correlation to the capital markets, and performed well in 2019. Investors will increase their allocation to CTAs in order to reduce tail risk across their portfolio.
Specialty long/short equity managers. Those that are perceived to have an information advantage or that focus on less efficient areas of the market will see inflows — possibly including managers that focus on small cap stocks, emerging markets and specific sectors. In addition, broad valuation differences and fundamentals are expected to influence equity returns more meaningfully in 2020, allowing more active managers to outperform.
Relative value fixed income. Strategies that provide liquidity to complex/less-liquid fixed income securities have replaced bank proprietary trading desks. Skilled managers generate most of their return through alpha and actively hedge market risk.
Hybrid private equity/hedge fund strategies. Most of these are focused on private lending/specialty financing and reinsurance. Although these financing strategies offer an attractive alternative to traditional fixed income, concern is growing about how they will perform in a market downturn.
- Increased Pension Fund Allocations
Most public pension funds have an actuarial rate of return assumption around 7.5%. With interest rates and credit spreads near historic lows, pension funds will look to hedge funds to enhance returns in one of two ways: either allocate some assets away from fixed income into to a diversified portfolio of uncorrelated hedge fund strategies, or view hedge funds as a “best in breed” manager and allocate part of their fixed income allocation to hedge fund strategies such as distressed debt, specialty financing, structured credit or relative value fixed income.
- Changing Views on Researching Investment Opportunities
Ten years ago, most institutional investors divided their team’s research responsibilities by fund structure; for example, an investment firm with a traditional long-only fixed income strategy would call on its fixed income team. Steinbrugge finds that today, more and more institutions use the “endowment model” approach, dividing up research by asset class. Some have an absolute return allocation, but this includes only hedge fund strategies with low correlations to the capital markets. All other hedge fund strategies are researched by the appropriate asset class team. He says this approach blurs the line between hedge funds and private equity, allowing the investor to better align the fund structure with the liquidity profile of the underlying securities.
- U.K. Hedge Funds Look to North America
Steinbrugge expects hedge fund firms in the U.K. — the world’s second largest market — to focus more on North American investors and significantly less on those in continental Europe as Britain exits the European Union. The EU, he notes, was created to provide free trade among its members, putting non-EU members at a disadvantage. This is particularly evident in the hedge fund industry where non-EU firms face high hurdles to comply with the EU’s regulatory framework, the Alternative Investment Fund Managers Directive.
- Evolving Organizational Structures
Rising costs of operating a hedge fund business with shrinking fees will continue to affect the business model of many organizations. Small and midsize hedge funds are increasingly outsourcing many parts of their business infrastructure as well as some research and investment-related activities to providers that can offer greater expertise in a more cost-effective manner while reducing fixed costs to the fund manager. In turn, Steinbrugge expects outsourcing to lead to full-time staff reductions at smaller hedge funds. Large firms that have built out substantial infrastructures will look to leverage these resources and diversify their firm revenue by either acquiring competitors or importing investment teams.
- Quality Marketing Essential for Asset Growth
In 2020, Steinbrugge expects continued concentration of hedge fund flows into a small percentage of managers, with 5% of funds attracting 80% to 90% of net assets within the industry. For an organization to succeed in this competitive environment, a top-notch product offering with a strong track record is not enough: 1,500 funds rank in the top 10% of hedge funds by performance. Hedge fund firms must also have a best-in-breed sales and marketing strategy that deeply penetrates the market and builds a high-quality brand. A firm can achieve this by either building out an internal sales team of seasoned professionals, leveraging a leading third-party marketing firm or a combination of the two. Steinbrugge expects the industry to continue to consolidate with fewer hedge fund startups and more closings. Firms without a high-quality sales and marketing strategy will have a difficult time raising assets and have a higher probability of shutting down.
- Continued Growth of Advisory Business Models
An increasing number of consultants, advisors, multi-family offices, funds of funds and outsourced CIOs are moving away from commingling client assets into a fund, and are instead adopting an advisory structure with bespoke portfolios of direct fund investments for each client. This is broadening the hedge fund industry’s investor base. Steinbrugge says most client service will remain focused on the advising entity, but this shift will cause hedge funds to bear the additional administrative costs of handling multiple accounts versus one commingled entity. In order to accommodate and attract this growing part of the market, he says, hedge funds must respond to the unique needs of the advising entities, including with flexibility around account minimums and by applying fee breaks based on cumulative assets originating from a single advisor.
- CFA Hedge Fund Performance Standards
Agecroft Partners strongly supports the CFA Institute’s effort to create and implement performance standards in the hedge fund industry, and considers it the right organization to lead this charge. Steinbrugge regrets, however, that the recently issued performance standards have failed to address some of the most important issues regarding hedge fund performance reporting. He expects acceptance of the new standards to be limited until they are redrafted.