By Donald Steinbrugge, CFA
Managing Partner, Agecroft Partners
Each year, Agecroft Partners predicts the top hedge fund industry trends through their contact with more than 2,000 institutional investors and 300 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. Below are Agecroft’s predictions for 2014.
1. Continued strong positive flows into the hedge fund industry driven by large institutional investors. 2014 should see the hedge fund industry reach a new all-time peak in assets as institutional investors continue to shift money out of fixed income and into hedge funds. This trend will continue as long as pension fund’s forward looking return expectation for a diversified hedge fund portfolio continue to be higher than those expected by their long only fixed income allocation. Those institutions who made the shift for calendar year 2013 were rewarded with the average hedge fund up approximately 8.5% verse down over 1.5% for the Barclays Aggregate Index which many pension funds use as a benchmark for their fixed income portfolios.
2. Long/short equity will see most demand among all hedge fund strategies. Long/short equity represented more than 40% of the hedge fund industry assets before 2008. The strategy then experienced large out flows to other hedge fund strategies including CTAs and various fixed income oriented strategies. Its market share of industry assets bottomed out at approximately 25% of industry assets in the beginning of 2013. 2013 saw this trend reverse, and we expect very high demand for long/short equity in 2014. Many investors believe it is the strategy with the greatest potential to generate double digit returns going forward, especially if long/short equity managers’ short books generate consistent profits once again.
3. High concentration of net flows going to a small percentage of managers with the strongest brands. Most assets will continue to flow to the largest managers; however, those small and mid-sized managers who excel at the following can succeed at raising assets: A) Offering a high quality fund,
Clearly articulating their differential advantages among investors’ hedge fund selection factors; B) Implementing a high quality distribution strategy that deeply penetrates the market.
This high concentration of asset flows will also continue to benefit the third party marketing industry as hedge funds struggle to complete in an increasingly competitive environment.
4. More hedge funds closing to new investors. With the high concentration of assets flowing to a small percentage of managers, many managers have surpassed their optimum asset capacity to maximize risk adjusted returns. These managers have morphed into asset gatherers who focus more on collecting large management fees versus generating maximum returns for their investors. However, there are an increasing number of mangers who prefer to focus on returns and this trend will lead to increased fund closures to new investors in 2014.
5. Slow implementation of the JOBS Act. Adoption of the JOBS ACT has been stymied due to additional legislation imposed by the SEC. Only firms that check off a box on schedule D are allowed to participate in general solicitation. Hedge fund firms are concerned that this will open them up to more frequent audits, onerous reporting requirements, and more difficult rules to prove accredited status of investors. We expect this adoption to remain sluggish until either a few firms benefit significantly from taking advantage of general solicitation in raising assets, which would cause others to follow or the SEC cracks down on firms who are currently violating non-solicitation rules and have not registered to take advantage of the JOBS ACT. These non-solicitation rules are very grey, and interpretation of the rules varies greatly throughout the industry. For example, what information may be included on websites, or in quotes to the media by hedge fund professionals?
6. Significant decline in hedge fund marketing activity through the European Union. Due to the passage of AIFMD, which imposes stricter and onerous requirements on hedge funds and requires registration in each individual country throughout the EU, marketing by hedge funds will decline significantly throughout the region. Most hedge funds will elect not to register in each country and will wait until 2015 before resuming their marketing activities when a single registration will allow a manager access to all EU markets.
7. Average hedge fund fee to decline. Although we see very little pressure on the standard fee that small and medium size investors are paying to hedge funds, there is significant fee pressure from large institutional investors. This pressure is expected to increase as large institutions represent a larger percentage of the market. Fee pressure is also intense in other fund structures including managed accounts and 40 Act funds. In addition, profit margins on UCITS structures, which have seen significant flows, are below those for traditional hedge funds.
8. Fund liquidity terms more in line with underlying investments. Before 2008, fund liquidity terms were determined by hedge fund of funds which often required monthly liquidity even for illiquid strategies. Today large institutional investors with long time horizons are heavily influential in changing fund terms in order to be better aligned with the underlying assets. For liquid strategies, like long/short equity, they are demanding monthly liquidity with no hard lock up, although a soft lock up might be acceptable. For less liquid strategies, they want to be protected from “fast money” and prefer to see less frequent redemption periods, longer notice periods, and potentially gate provisions and hard lock ups depending on the strategy.
9. Strong Growth of 40 Act funds. We expect a significant increase in the amount of assets following into 40 Act single strategy hedge funds and funds of hedge funds, along with the launch of many new 40 Act funds into the market place. Early adopters to launch 40 Act funds were very successful raising significant assets with often inferior products compared to traditional hedge funds attracting institutional assets. As the competition increases, it will be more difficult to raise assets. To be successful in this channel, a strong distribution partner is essential.
10. Positive flows to Hedge Fund of Funds with specific industry niche expertise. Hedge fund of funds with diversified portfolios consisting of the largest hedge fund managers will continue to see their assets erode as more and more pensions begin to replicate this strategy. However, those that excel at a specific niche should have success in raising assets. These three niche areas include: A) Strategy Focus, which would focus on specific strategies, regions, or emerging managers; B) Fund Structure, including managed accounts, UCTS, and 40 Act funds; C) Investor Segments, which might include focusing on insurance company general accounts, investment advisors, or a geographical area where the firm may be viewed as the local expert.