(Investment Week) -- Despite the plethora of negative articles about the hedge fund industry, hedge fund assets have reached an all-time high five quarters in a row.
There is clearly a disconnect between the mainstream media's coverage of the industry and the reasons why investors continue to allocate to hedge funds.
Across the hedge fund investor landscape, we see a significant improvement in sentiment towards the industry. We forecast industry assets will grow by 5.5% over the next 12 months.
Large rotation of assets based on changes in strategy preferences and relative performance of individual managers
While the past few years have been challenging for the performance of hedge fund indices, we have seen large dispersions of performance across strategies and among managers with similar styles. Some strategies and individual managers have performed quite well.
Underperforming managers will experience above average withdrawals as investors grow increasingly impatient with disappointing performance from high priced investment structures. Some of these assets 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 where they think active managers have more opportunity to add value.
Strategies that will lose assets include:
• Traditional long/short equity focusing on the developed markets. A large percent of managers have delivered negative alpha over the past five years. Investors have become overwhelmingly disappointed in, and will continue to withdraw from, managers who consistently fail to deliver on their value proposition.
• High beta fixed income managers. Many investors believe that these managers face strong headwinds with rising interest rates and widening spreads.
Meanwhile, strategies that will gain assets include:
• Quant. These strategies comprise multiple categories and have been responsible for a disproportional share of industry growth. Currently, seven of the 11 largest hedge fund firms are quantitative managers.
• Asia long/short equity. The IMF predicts two thirds of world growth will come from Asia over the next five years. Less than 5% of hedge fund industry assets are invested with Asia-based managers. Today, Asian markets typically offer lower P/E multiples, higher volatility and less institutional ownership, all of which should benefit active management.
• Reinsurance. There has been a significant recent increase in demand due to expected 2018 price increases driven by the major hurricanes, earthquakes, and wildfires in the third and fourth quarters of 2017.
• Higher turnover fixed income. Strategies that provide liquidity to complex/less liquid fixed income securities have replaced bank proprietary trading desks. Skilled managers generate most of their return through alpha and actively hedge market risk.
• Strategies that blur the lines between private equity and hedge funds. Most of these are private lending/specialty financing. While there is growing concern about how some will perform in a market downturn, they offer an attractive alternative to traditional fixed income.
Arms race for Alpha
As mentioned previously, most long/short equity managers have been struggling recently to add value and are looking for ways to enhance their investment process.
The industry is experiencing an information arms race with respect to how much information can be gathered and how quickly it can be processed.
Information advantages are often short-lived, and many managers are investing in a host of new technologies such as quantitative analytics, alternative data sources and artificial intelligence in an attempt to enhance their decision-making and improve traditional investment processes.
Information and technology are being used to increase efficiency and accuracy in sourcing information, researching ideas and executing investments.
"Data Scientist" has become a key position at many leading edge firms responsible for amalgamating and leveraging information from web traffic, social media sentiment, online chat rooms, and GPS and satellite imagery to generate actionable forecasts on industries and companies.
Increase in hedge funds shutting down
The hedge fund industry remains over saturated with an estimated 15,000 funds. We believe approximately 90% of all hedge funds do not justify their fees, as evidenced by the mediocre returns of hedge fund indices.
Unhappy with poor performance, investors are increasingly more likely to redeem from underperforming managers leading to an increase in fund closures.
This will impact both large established managers as well as emerging managers. The hedge fund industry is Darwinian and constantly evolving.
Some prominent managers' strategies may no longer offer the alpha-generating opportunities that historically drove performance and some large managers are just too big to maintain an edge.
But managers with less than $100m in assets, which represent a majority of the hedge funds, are being squeezed from both the expense and revenue sides of their businesses.
No matter the size or tenure of the fund, poor performance will accelerate the outflows of capital and in some cases result in fund closures.
Unfortunately for many, the reverse is not true. Strong performance in a sustainable strategy is simply not enough to generate inflows of capital. Hedge fund flows are increasingly driven by brand and distribution, which smaller hedge funds lack.
We estimate only 2% of assets are flowing to these managers. As a result, we expect the closure rate to continue to rise for small- and mid-sized hedge funds.
Pension funds evolving how they use hedge funds
Very few pension funds have eliminated their hedge fund exposure because most believe hedge funds can enhance the risk-adjusted return of the overall portfolio.
Most pension funds continue to treat hedge funds as a separate asset class, offering low correlation to the equity and fixed income markets and expected returns of 4% to 6% that compare favorably to their fixed income portfolio.
More recently, some pension funds are adopting more of an "endowment model" approach towards investing in hedge funds.
No longer viewing them as an asset class, these investors are assessing the market exposure and risk profile of individual hedge fund strategies, and evaluating their potential to be a best-in-breed manager within the pensions' overall allocation strategy.
Using this approach, hedge fund strategies are allocated to categories and measured against tailored benchmarks that more accurately reflect their investment strategy and underlying securities rather than the fund structure.
These buckets broadly include equities, fixed income and uncorrelated, though there is often further delineation. We believe this will have a long-term positive impact on pension fund portfolios and the hedge fund industry.
Growth of global hedge fund distribution
Most US hedge funds over the past five years have avoided the opaque, complex legal and regulatory requirements imposed by jurisdictions outside of the country in favour of focusing marketing efforts on the highly competitive US marketplace, where many investors are contacted by thousands of firms a year.
With the continued development by various specialist law firms of products that identify and simplify the requirements of marketing in more than 100 countries around the world, we expect growth in marketing of funds outside the US.
Many of these countries have low or manageable barriers to entry, while others have potential benefits high enough to justify meeting certain reasonable requirements made clear by such products.
In many of these jurisdictions, a significant number of investors are looking for high quality hedge fund managers but have been underserved.
We expect an increasing number of hedge fund managers to use these products to either market directly to these lesser known jurisdictions, if they are able to identify who to call on or to hire third party marketing firms who have established relationships to target specific regions or countries on their behalf.
Bullish on cryptocurrency industry, despite potentially one of the largest bubbles in capital markets history
Cryptocurrency is in its infancy stage and will continue to experience tremendous innovation, evolution and exponential growth over the next decade. It seems all but certain that at some point cryptocurrencies will be commonly used by consumers.
It is estimated there are currently over a thousand cryptocurrencies along with numerous services providers to the industry.
Individuals who can effectively evaluate the landscape, understand how the marketplace is evolving and determine who will be the future leaders in the industry will be highly successful.
There are already more than 120 hedge funds focused on cryptocurrencies and block chain technology. We expect this number to increase 2 to 3 times in 2018.
Hedge funds will play a much larger role in the industry once correlations between cryptocurrencies and other industry players decouple and as future markets are expanded to other cryptocurrencies.
But it is important to differentiate between the future growth of the industry and the current valuation of its largest player: Bitcoin.
We believe Bitcoin's current price has been bid up by hype and speculation to potentially create one of the largest bubbles in financial market history.
Unlike a bond that pays interest or an equity that generates earnings, the only thing supporting the value of Bitcoin is supply and demand.
Thus far, the market has been fuelled by speculators, and the price volatility over the past few weeks is evidence of the fragility of these markets.
While Bitcoin risks increased competition from other cryptocurrencies, the entire cryptocurrency market faces uncertainty with regard to government regulation, as well as the risk of real loss from cyberattack, which will very likely carry with it a loss of investor confidence.
Increase in outsourcing
The quantity and quality of hedge fund service providers has reached the level where hedge funds are increasingly attracted to outsource many parts of their business infrastructure, as well as some research and investment related activities.
This includes IT, legal, compliance, third party marketing, back office, data providers, and analytics.
We expect full-time employees of hedge funds to decline over time as more services are outsourced to companies with greater expertise that can provide services in a more cost-effective manner.
Source: Investment Week