Alt Investments
Ten Potential Trends To Watch Among Hedge Funds This Year

A firm specializing in the hedge fund space considers 10 trends it considers that may, or will, unfold this year.
As 2017 gets under way, one area where investment professionals might try and predict developments is in the $3 trillion hedge fund sector. A prominent consulting and third-party marketing firm, Agecroft Partners – regularly commenting on such trends – considers the most significant themes it sees for the sector this year. The managing partner of Agrecroft, and a significant figure in the investment industry, is Donald A Steinbrugge.
These comments have been reproduced by this publication with permission. The editors of Family Wealth Report invite readers to respond; they can email tom.burroughes@wealthbriefing.com
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; and
-- 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
per cent of industry assets and average gains of 5 per cent
resulting in a net increase of 2 per cent of industry
assets.
4. Increased alpha due to decreased correlations and
higher volatility: President-elect Donald Trump plans to
make major changes to the US 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 anaemic 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; and
-- 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.
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 per cent vs. the HFRI dollar
weighted composite that was up only 1.90 per cent. 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 per cent 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 per cent 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 per cent 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 haemorrhaged 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.