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1. Hedge fund industry AUM to reach all-time high driven by net inflows
Hedge fund industry assets will reach an all-time high in 2021 driven by one of the largest positive net inflows into the hedge fund industry in over a decade. Although the hedge fund industry has grown significantly over the past decade, the growth has been primarily generated by performance rather than positive net flows. Barclayhedge reports only $164 billion of positive net flows over the past 10 years and $283 billion of outflows over the last 3 years.
The market volatility of 2020 stress-tested the hedge fund industry and, for the most part, fund performance met investor expectations. Specifically, modest drawdowns in Q1 followed by a recovery and continued positive performance led to growing investor confidence. The growth in hedge fund industry aum will largely come from institutional investors allocating away from low yielding fixed income investments to hedge fund strategies with higher expected returns, as well as strategies that are uncorrelated to the performance of the capital markets.
2. Increased activity in hedge fund searches
Three factors will contribute to 2021 being one of the best capital raising environments that the hedge fund industry has seen in the past decade. First, as discussed in trend One above, we expect strong positive industry net asset flows.
Second, we see pent up demand for manager search activity. Most search activity was put on hold due to Covid-19, which led to the closing of almost all multi-person offices around the globe. The first priority for investors was to address fund “blow-ups” within their portfolios. At the same time, the uncertainty triggered by the late March sell-off put most investors in a holding pattern until the markets were confident that central bank intervention would successfully calm the capital markets. Additionally, most of Q2 and Q3 were consumed by people adjusting to a remote/home work environment and establishing internal and external communication protocols. Travel restrictions effectively cancelled all in-person meetings and further slowed the research process until virtual communication was broadly adopted later in the year.
Third, market volatility led to the largest dispersion of performance in over a decade across managers within similar strategies. This has historically led to higher manager turnover both within and across strategies, and we expect that to happen again in 2021.
We expect 2021 search activity to be the most robust in years driven by positive flows, pent up demand and reallocations stemming from a broad dispersion of returns.
3. Resurrection of Long Short Equity
Long-short equity once dominated the hedge fund industry. For decades, the strategy was managed by many of the top-performing, marquee names in the industry and peaked at approximately 40% of industry assets. Over the past decade, the average long-short equity manager’s exposure adjusted performance significantly trailed the S&P 500 as huge asset flows propelled the index higher. Importantly, the strategy generally showed little evidence that it could consistently add value (alpha) through stock selection that would justify a hedge fund fee structure. This underperformance caused many investors to lose confidence in long-short equity strategies and shift a large percentage of assets into other hedged strategies. At mid-year 2020, long-short equity had declined from its peak to just over 25% of industry assets.
Part of the difficulty in stock selection over this past decade stems from the large asset flows into passive S&P 500 index funds and large tech names. The flows not only propelled the index and large growth stocks higher, but also created massive distortions in relative valuation between large and small-cap stocks, growth and value stocks, and US and non-US stocks. This has created an ideal environment for managers to add value through fundamental research. We saw some corrections over the past quarter but there remains a long way to go until relative valuations are more in line with historical averages. As a result, we expect greater demand for long-short equity managers and strong exposure adjusted returns relative to the S&P 500 and other broad market indices.
4. Greater focus on ESG and diversity
There has been a lot of discussion about applying ESG investment principles in the hedge fund industry historically but, until recently, little action. In the last few years, European institutions have been ahead of the US in integrating ESG into their investment diligence. Now, ESG looks to be reaching a ‘tipping point’ and will likely gain universal traction among institutional investors.
The social and economic inequities magnified by the spread and treatment of Covid-19 and the global movements in support of social justice will be the catalyst; pension funds, endowments foundations and sovereign wealth funds that make up approximately 48% of hedge fund industry assets are making their voices heard on these issues. ESG principles will have a meaningful and growing impact on the companies in which hedge fund managers can invest.
As they are more broadly implemented, ESG criteria are also being applied in more sophisticated ways. ESG guidelines began as mostly limiting criteria (e.g. no alcohol, no tobacco, etc). They are now being applied at the individual security level through third party ratings - the companies with the lowest ESG rating are excluded from ESG portfolios.
Some investors are targeting sub-categories of ESG like climate change, where the investment mandate is focused on renewable energy. These are currently more typical on the private equity side of the business, but we expect this type of thinking to find its way into hedge fund investments as well.
While ESG has been primarily focused on the securities in which a hedge fund manager invests, more focus is being placed on the manager itself. As such, diversity of their workforce is becoming part of the manager research and due diligence process for many institutional investors. We believe this is just the beginning of a very strong trend. Hedge fund managers will be well-served to proactively embrace diversity as a critical path to their long term success.
5. The line between hedge funds and private equity continues to blur
We noted in our previous trend pieces that the line between long-only structures and alternatives was blurring as allocators moved toward organizing their research by strategy or asset class. This blurring continues more specifically within the alternative investment industry. It has become broadly understood that hedge funds are not an asset class; they are fund structures.
Over the past decade, private equity firms and hedge funds have increasingly been offering similar strategies with different fund structures. A drawdown structure for private equity and an evergreen structure for hedge funds. Among others, examples of this include distressed debt, specialty finance and reinsurance.
More recently, hedge fund managers are offering both drawdown and evergreen funds. At the insistence of investors, managers are appropriately focused on aligning fund structures with the underlying liquidity of the securities in which they are investing. This trend is further impacting the way allocators structure their research departments. Research departments are largely moving further away from teams siloed by fund structure and toward research coverage organized by strategy or asset class.
This convergence of hedge funds and private equity will impact all aspects of the industry. Capital introduction events, for example, already often include private equity firms. This convergence will also be seen in industry journals and trade organizations, databases, service providers, and conference organizers.
6. Fee compression: 1 & 15 becoming the new fee schedule for large institutional investors
Fees have been a topic in the hedge fund industry for over a decade. As the attention and pressure take effect, the hedge fund industry is experiencing a bifurcation of fees. While 2 & 20 is no longer the norm, smaller investors are typically paying average fees of 1.5 & 20, while institutional investors are paying significantly lower fees with an estimated average of 1 & 15. Recognizing the importance of institutional clients, managers have continued to tailor fee terms to meet the specific needs of these large allocators. Many have adopted a ‘give and take’ approach with respect to balancing terms including management fees, performance fees, hurdles, performance fee crystallization periods and lockup provisions.
7. In-person meetings to resume in Q4 of 2021, resulting in increased asset flows to mid-sized firms
Since the start of the pandemic, most assets have flowed to larger managers. Most often, investors and/or their investment consultants had already visited these managers at some point in the past. The lack of in-person meetings, a critical and oftentimes required step in finalizing an asset allocation, made fundraising disproportionately more difficult for small and mid-sized firms.
We expect that by the 4th quarter, a large portion of the population will have received their second immunization shot. This will lead to the resumption of onsite meetings and benefit small and mid-sized fund managers. Although in-person meetings should resume and become more frequent over the second half of 2021, we do not expect in-person conferences to resume any sooner than the 1st quarter of 2022.
8. Virtual Meetings and Virtual Cap Intro events are here to stay
The global pandemic has forced the industry to adapt and incorporate virtual meetings to conduct manager research. Reduced travel time and travel expenses have shown both managers and investors how efficient virtual meetings can be. Investors have also found virtual meetings to be more effective in many respects. Investors have taken advantage of scheduling flexibility to prioritize and optimize participation in manager meetings. As meetings are frequently recorded, they can be shared to broaden the input from their research team. Investors have also observed that the most senior members of the hedge fund team frequently participate in virtual meetings, leading to higher quality meetings.
As a result, we expect a large portion of introductory meetings and early-stage research to continue to be conducted virtually. It is likely that later stage due diligence meetings will still take place onsite at the manager’s office whenever possible.
For all of the reasons above, we also expect virtual cap intro events to continue long after travel limitations are behind us. To offer some context to the magnitude of this change, in 2019 our Gaining the Edge - Hedge Fund Conference offered both in-person and virtual meetings between managers and investors. Almost no investors registered for virtual meetings. In 2020 approximately one thousand people participated in our Gaining the Edge - Virtual Cap Intro Event. The pandemic looks to have been the catalyst for permanent change.
Another outcome from the adoption of early-stage virtual meetings and virtual cap intro events is that both smaller funds and those not located in the top global financial hubs will benefit from expanded access to investor meetings.
9. Healthcare Institutions are helping to drive growth within the alternative investment industry
Healthcare institutions are emerging as a separate category among investor segments. Primarily as a result of the aging US population as well as advances in medical technology, this segment has been, and will likely remain, one of the fastest growing. Many healthcare institutions have amassed multi-billion dollar pools of assets divided across foundations, endowments, pension funds, operating funds and self-insurance reserves. As these pools of assets have become substantial, healthcare organizations have built sophisticated investment departments with expertise in alternative investments. With that, we see large and growing allocations to alternative investments.
10. Increased regulatory scrutiny of the hedge fund industry
The hedge fund industry has been blamed for many things over the past several decades. The accusations usually accompany a market sell-off or an investors’ unexpected poor performance. Most recently, hedge funds have been blamed by some finance officials for the reduction in liquidity of the Treasury market during the sell-off in Q1 of 2020. Of course, compliance with the Volcker Rule following the Great Financial Crisis left hedge funds and other pools of private capital as the only liquidity providers in the market. The irony is not lost here. Nonetheless, as the new Biden administration takes office, and Janet Yellen is appointed to lead the Fed, we expect an extensive review of transparency requirements and leverage limits within the hedge fund industry.
Related: How Do You Select a Long/Short Equity Hedge Fund Manager?