By Don Steinbrugge, CFA
Each year, Agecroft Partners predicts the top hedge fund industry trends through its contacts with more than 2,000 institutional investors and hundreds of hedge fund organizations. Because the hedge fund industry is very dynamic and constantly changing, it is important for firms to anticipate what changes are likely to occur. Those who effectively evolve with the industry will succeed, while stagnant firms will be left behind. This is what we believe is likely to occur in 2015:
Greater Alpha Due to Higher Volatility. Since 2009 most hedge fund returns have been driven by market beta due to rising equity and fixed income valuations. This was enhanced by high correlations and lower volatility within the capital markets. Since September, there has been an increase in volatility in the capital markets and we expect this to continue as volatility levels move closer to historical averages. Larger price movements make it easier for skilled hedge fund managers to add value through security selection when security prices reach price targets more quickly, thus, enabling capital to be reinvested in other opportunities.
Greater Demand For Hedge Fund Strategies That Benefit From Increased Volatility. These strategies include market neutral equity, arbitrage strategies, global macro, CTAs, long/short equity and fixed income trading oriented strategies. Not only will these strategies be in demand because of their increasing ability to generate alpha, but also as a hedge to all time high equity and fixed income prices.
Smaller Managers Will Continue to Outperform. One of the biggest issues within the hedge fund industry has been the high concentration of flows to the largest managers with the strongest brands. This has caused many of these managers’ assets to swell well past the optimal asset level to maximize returns for their investors. As they become larger, it is increasingly difficult to add value through security selection. Large managers also have an incentive to reduce the risk in their portfolio in order to maintain assets and thereby increase the probability of continuing to collect large management fees from their client base. Finally, it becomes more difficult to stay motivated for some of the largest managers once their personal wealth reaches the stratosphere. For example, put yourself in their shoes “Should I do research in my office all day Saturday to enhance returns for the fund or fly on my G6 to my ocean front house in the Caribbean, where I will be partying all weekend with super models and celebrities?”
More Hedge Funds Shutting Down. Hedge funds will shut down at an increased pace driven by four factors: 1) Agecroft estimates that the current number of hedge funds is near an all-time high of fifteen thousand. Given a consistent rate for hedge funds ceasing operations, hedge fund closures should also be at an all-time high. 2) This increase in hedge fund managers has reduced the average quality of hedge funds in the industry. Many of the lower quality managers will experience a higher rate of closing down, which is good for the industry. 3) Increased volatility in the capital markets increases the divergence in overall return between good and bad managers. This in turn increases the turnover of managers as bad managers get fired and money is reallocated to those who outperform. 4) The competitive landscape for small and mid-size managers is becoming increasingly difficult. They are being squeezed from both the expense and revenue side of their businesses. In addition, having a superior quality product alone is not enough to generate inflows of capital. Hedge fund flows are being driven more and more by brand and distribution, which these hedge funds lack. As a result we expect the closure rate to rise for small and mid-sized hedge funds.
Hedge Fund Industry Assets to Reach All-time High in 2015. Despite all the negative stories recently about the industry, including: an increased level of fund closures, CalPERS pulling out of hedge funds and hedge funds underperforming the S&P 500, total hedge fund industry assets will reach a new all-time high in 2015. This will be fueled by a combination of investors moving assets out of long only fixed income to enhance forward looking return assumptions and other investors shifting some assets out of the equities to hedge against a potential market sell-off. We expect hedge fund industry assets to rise by $210 billion or 7 percent which was derived from a forecast of 2% increase due to net flows and 5% from performance.
Founder’s Share Fee Structure Becomes Mainstream For Small Hedge Fund Managers. A Founders’ share class is a 25% to 50% discount on standard hedge fund fees that began as a way to incent investors to invest day one in a new fund. Over the past couple years, its use has been greatly expanded to include a significant percentage of hedge funds under one hundred million in assets. This assets ceiling is increasingly being raised to two hundred million and beyond for investors willing to either allocate a large dollar amount or accept a longer lock up. This trend adds downward pressure on hedge fund industry fees that are also being squeezed by large institutional investors.
‘40 Act Hedge Fund Marketplace Becoming Increasing More Competitive. The number of hedge fund ’40 Act funds has ballooned over the past couple years which has made it increasing more difficult for new entrants or smaller managers to raise assets unless they are aligned with a strong distribution partner.
AIFMD Significantly Reducing Hedge Fund Marketing Activity in Europe. US marketing activity in the Euro-Zone has declined significantly due to AIFMD and we do not expect it will increase until hedge funds can register across the Euro-zone with a single registration. Europe has historically accounted for approximately 25% of hedge fund asset flows to US based managers. This legislation is hitting smaller managers disproportionally hard because they lack the resources to register in individual countries. In addition, European based investors tend to be more willing to invest in smaller managers due to their higher return potential. This legislation is also hurting European investors who are not seeing many of the top emerging managers.
Growth in Outsourced CIOs. An increasing number of endowments and foundations are outsourcing the investment management of their funds to Outsourced Chief Investment Officer (OCIO) due to both the rising cost of staffing an investment office and poor returns from their portfolio. This is good news for the OCIO industry that has seen a flood of new competitors over the past 5 years, however this will also lead to significant fee pressure due to the increased competition. This is a major change from the environment a few years ago where there was little fee pressure and investors often felt lucky to be accepted as clients.
Social Media. The use of social media by hedge fund managers, investors and service providers continues to expand at an accelerating rate. Social media is being used for research, to build stronger relationships and help promote a firm’s brands in the market place. Some managers are also using it to promote their investment ideas in order to create a catalyst for the security. The most commonly used social media is LinkedIn, which is broadly used throughout the industry. In 2014, Twitter was used by many people in the industry for the first time and this is expected to increase in 2015. Finally, we are beginning to see some use in YouTube where organizations are creating videos that can be posted on websites, distributed through social media or emailed to a distribution group.