Top 10 Hedge Fund Industry Trends for 2017

Written by: Don A. Steinbrugge, CFA | Agecroft Partners

Each year, Agecroft Partners predicts the top hedge fund industry trends through our contact with more than two thousand institutional investors and hundreds of hedge fund organizations. The hedge fund industry is very dynamic, and participants are best served by anticipating, rather than reacting to, change. Below are Agecroft’s predictions for the biggest trends in the hedge fund industry for 2017.

1. Evolution in hedge fund fee structures for large institutional allocations.

Hedge funds fees remain under extreme pressure by large institutional investors. Except for managers whose strategies are capacity constrained or those who have enjoyed excess demand for their offering, we will see continued evolution in how hedge fund fees are structured to attract and retain large institutional investors. We see managers pursuing these three paths:

Schedules that tier fees based on the size of an allocation. This model has been standard practice in the long-only space for decades. This permits managers to avoid individual negotiations by reducing fees for larger allocations through a sliding scale fee schedule available to all investors.

Tailored fees to address specific issues of prospective institutional investors. This involves give and take across multiple factors including not only management and performance fees, but also performance hurdles, performance crystallization time frames, longer lock-ups, guaranteed capacity agreements, and potential revenue shares or ownership stakes in a management company in return for early stage investments.

Hedge fund light management fee only. Many hedge funds are developing lower fee strategies that can be used in a ‘40 Act structure, institutional share class or separate account. These structures are growing in popularity with large public funds focused on reducing fees.

2. Continued outflows of assets from the hedge fund industry by large institutional investors, though less than anticipated.

Despite the benefits hedge funds can provide to a diversified long only portfolio, we will continue to see hedge fund redemptions by large institutional investors in response to ongoing pressure from the media, union employees, and politicians. To address the concerns of their constituents, the investment professionals of public pension funds will be required to more clearly communicate why they invest in hedge funds and how their performance should be evaluated. There are multiple reasons for investing in hedge funds including reducing downside volatility, enhancing the risk adjusted returns of their portfolios or viewing hedge funds as best in breed managers. Comparing hedge fund performance to that of equity markets is typically inappropriate.

3. Hedge fund industry assets to reach an all-time high in 2017 for the 9th year in a row.

Despite the plethora of negative articles about the hedge fund industry and continued net redemptions from large institutional investors, we believe hedge fund industry assets will reach an all-time high in 2017. This will be driven by a disconnect between the mainstream media’s coverage of the industry and the reasons why investors continue to allocate to hedge funds. We forecast redemptions of 3% of industry assets and average gains of 5% resulting in a net increase of 2% of industry assets.

4. Increased alpha due to decreased correlations and higher volatility.

President-elect Donald Trump plans to make major changes to the U.S. tax structure, infrastructure spending, international trade deals, and health care spending, among many other initiatives. These changes will impact companies, sectors and markets differently, causing correlations to decline and volatility to increase closer to historical averages. Larger price movements provide more opportunities for skilled hedge fund managers to add value through security selection in strategies that capture greater price distortions in the market and accelerate performance as security prices more quickly reach price targets.

5. Large rotation of assets among managers based on relative performance and changes in strategy preferences.

While the past few years have been challenging for the performance of hedge fund indices, not all managers and strategies have performed poorly. We have seen large dispersions of performance across strategies and among managers with similar styles. Underperforming managers will experience above average withdrawals, forcing some to close down. A vast majority of these assets will be re-circulated within the industry. Some will be reinvested with better performing managers in the same strategy. Most will flow into other strategies as investors re-position their portfolios based on capital market valuations and their economic forecasts. We see 2 major themes for assets flows:

Greater demand for hedge fund strategies with low correlations to long only benchmarks. Capital markets valuations are hovering near all-time highs. There are potential economic time bombs in China relative to foreign reserves, a housing bubble and the banking system. Concern remains high regarding some of the weaker countries in the European Union, particularly Greece and Italy, amid anemic global economic growth and global monetary authorities with little dry powder left to stimulate economies. Against this backdrop, many investors are becoming increasingly concerned about downside volatility. In response, some of the strategies that will see a continued increase in demand include: relative value fixed income, market neutral long/short equity, commodity trading advisors (CTAs), direct lending, volatility arbitrage and reinsurance due to their perceived ability to generate alpha regardless of market direction and as a hedge against a potential market sell-off.

Greater demand for hedge fund strategies that benefit from lower correlations and increased volatility. This applies to many of the strategies above as well as long/short equity and fixed income trading oriented strategies. This is particularly good news for the long short equity sector, where many managers have recently experienced significant poor performance and outflows.

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6. Smaller managers will continue to outperform.

Year to date through November 2016, smaller funds significantly outperformed larger funds as demonstrated by the HFRI Fund weighted composite that was up 4.54% vs. the HFRI dollar weighted composite that was up only 1.90%. 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. Almost 70% of industry assets are invested with firms that have over $5 billion in assets under management. 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. To retain assets, large managers also have an incentive to reduce the risk in their portfolio which, in turn, lowers expected returns.

7. Increased flows to small and mid-sized hedge fund managers.

Despite studies that show stronger performance by younger and smaller funds, hedge fund firms with $5 billion or more currently manage 68.6% of industry assets, up from 61% in 2009, based on research from HFR. This trend will reverse due to increased sophistication of institutional investors, poor recent performance of many of the largest well known hedge funds, the pressure institutional investors are receiving to enhance returns and the belief that smaller, more nimble managers have an advantage in a performance environment increasingly dependent on security selection. This is especially true for small managers operating in less efficient markets or capacity constrained strategies. However, these flows will be concentrated in a very small percentage of managers.

8. High concentration of net flows going to a small percentage of managers with the strongest brands.

The hedge fund market place is highly competitive. Most full time hedge fund allocators use a funnel approach to select managers. A typical institutional investor will be contacted by thousands of hedge funds a year, meet with around three to four hundred, have follow-up meetings with fifty and hire two. Most allocations will go to a small percentage of managers that fall into one of two categories. The first category is comprised of the largest managers with strong brands and distribution networks. The second includes those small and mid-sized managers who excel at offering a high quality investment product, clearly articulate their differential advantages among investors’ hedge fund selection factors, and implement a high quality distribution strategy that deeply penetrates the market.

9. Continued increase in hedge funds shutting down.

The hedge fund industry is over saturated with an estimated 15,000 funds. We believe approximately 90% of all hedge funds do not justify their fees, which is evidenced by the mediocre returns of hedge fund indices. Fed-up with poor performance, investors are increasingly more likely to redeem from underperforming managers leading to an increase in fund closures. We anticipate greater capital markets volatility. Such an increase will magnify the divergence in overall returns between good and bad managers and highlight these underperforming managers. Finally, notwithstanding their potential to outperform larger managers, the competitive landscape for small and mid-size managers is increasingly difficult. They are being squeezed from both the expense and revenue sides of their businesses. A superior quality product alone is not enough to generate inflows of capital. Hedge fund flows are increasingly driven by brand and distribution, which these hedge funds lack. As a result we expect the closure rate to continue to rise for small and mid-sized hedge funds.

10. Positive flows to hedge funds of funds with specific industry niche expertise.

The hedge fund of funds industry has hemorrhaged assets since 2008. One of the major criticisms has been the double layer of fees. With a majority of hedge funds willing to offer reduced fees for larger allocations, many funds of funds are no longer charging double fees because their fee is offset by a reduced fee structure from the funds in which they invest. This lower fee structure is competitive with what investors are paying for direct investments which makes the expertise these Funds of Funds offer more compelling. Niche expertise that should see growth includes funds of funds that focus on emerging managers, and strategies that require longer lock-up vehicles to take advantage of inefficiencies in less liquid investments.