Don Steinbrugge, Agecroft Partners

Agecroft Partners predicts hedge fund industry trends for 2012 

Agecroft Partners predicts 2012 will be the best year for net flows into the hedge fund industry since 2007 despite the lacklustre investment performance for the industry in 2011. According to Agecroft’s Don Steinbrugge, this conclusion is based on several dominant and emerging trends the firm has identified through their conversations with more than 300 hedge fund organisations and 2,000 institutional investors during 2011…

Some of the trends they have observed include: 1. Improvement of net capital flows across most major hedge fund investor segments  2. Large rotation of assets between managers based on relative performance and changes in demand for strategies  3. Increased net flows to small and mid-sized hedge fund managers  4. Continued concentration of hedge fund flows into a small percentage of managers  5. More retail oriented hedge funds in the marketplace 6. Increase in both hedge fund closures and launches  7. Greater hedge fund investor concentration risk due to more consultant-based asset placement  


Improvement of capital flows across most major hedge fund investor segments
 
Below is a brief overview of some of the hedge fund investor segments
 
Pension Funds:  Pension funds will be the largest contributor to growth in the hedge fund industry in 2012 as they continue to strive for enhanced risk-adjusted returns in order to decrease their massive unfunded liability.  We are in the middle of a 10 year trend during which we will see an increase in the number of pension funds allocating to hedge funds along with an increase in the average percentage allocation.  In addition, the hedge fund investment path taken by pension plans will continue to evolve.  Historically, many pension plans started with an investment in fund of funds, followed by investments directly into the largest well-known hedge funds.  They then focused on alpha generators and finally evolved into the endowment fund best-in-breed strategy of investing.  More recently, some of the larger pension funds have begun to skip the first step of investing in fund of funds by investing directly in hedge funds.  This will have long-term implications for the hedge fund of fund industry.
 
Endowments and Foundations:  The endowment and foundation market is characterized by perpetual growth, as these organization are structured to pay out only about 75% of their long-term expected earnings.  Adding to this growth is the fact that many receive ongoing contributions and, more importantly, many new organizations are created each year.  Since many of the largest funds are fully allocated to the hedge fund space, growth will be highly correlated to the annual increase in assets for these organizations, which Agecroft projects will be 10% to 20% annually. Stronger growth will come from mid-sized organizations that are under-allocated to hedge funds and are evolving their portfolios to look more like their larger peers.
 
Family Offices:  This segment of the market place has experienced significant growth as more and more super high net worth families hire full-time staff to manage their assets. This growth has recently been fueled by fortunes made in the technology, private equity and hedge fund industries. Family offices will continue to be very active allocators to hedge funds as their investment staff become more sophisticated and knowledgeable in the hedge fund space.
Hedge Fund of Funds: The fund of fund market place has experienced net redemptions 4 years in a row, although during the past 2 years redemptions have been more modest.  We expect net redemptions to continue in the hedge fund of fund industry in 2012.  This will be driven primarily by significant withdraws from the largest pensions funds that are choosing more frequently to make direct investments in hedge funds in order to save on fees.  These redemptions will be somewhat offset by smaller and mid-sized pension funds and insurance companies that are increasing their allocations to fund of funds along with high net worth individuals that are advised by financial planners. There will always be a place for fund of funds within certain sectors of the hedge fund investor community and those fund of funds that can change with the evolving landscape will be the most successful going forward. 
Consultants: The hedge fund consultant marketplace has seen explosive growth as more institutional investors and large family offices begin to invest directly in hedge funds.  These consulting firms have seen their hedge fund assets under advisement balloon in size, which at some point will create difficulties for these firms in adding value to their clients’ portfolios.  2012 will see continued growth in this industry with increased competition from new entrants into the marketplace, including traditional institutional consultant firms and hedge fund of fund organizations that create customized separately managed portfolios for large institutional investors.
 
Large rotation of assets between managers based on relative performance and changes in demand for strategies
 
2011 was a very difficult year from a performance standpoint for a majority of hedge fund managers for 2 primary reasons.  First, macro events created significant volatility in the capital markets which increased the correlation of returns between individual securities.  These significant moves in the market dominated the fundamental analysis that characterizes most hedge fund managers, leading many managers to get whipsawed by the markets.  Second, most global capital markets generated negative returns for the year.  Since most hedge funds tend to be long biased, these declining markets were a large headwind for most managers.  However, not all managers performed poorly; some were able to effectively navigate through the volatility to generate strong returns, which created significant deviation in performance between managers with similar styles.  Those managers that underperformed will experience above average withdrawals, with a vast majority of these assets being re-circulated within the industry.  Because of the length of hedge fund notice periods and liquidity provisions, there will be a lag in these flows which should materialize in the 1st half of 2012.
 
Over the past 4 years we have seen a dramatic change in how hedge fund investors allocate across strategies.  For example, based on HFR data, in 2011 equity hedge fund strategies totaled  $539 billion which was down from $684 billion in 2007.  However, macro hedge fund strategies (including CTAs) in 2011 totaled $434 billion which was up dramatically from $288 billion in 2007. These changes are seen across all major hedge fund strategies.  We will continue to see significant realignment of assets across all hedge fund strategies as investors try to position their portfolios based on current and projected economic environments.
 
Increase flows to small and mid-sized hedge fund managers
 
After receiving only a small fraction of net flows in 2009 and 2010, small and medium-sized hedge funds received a larger percentage of net flows in 2011.  This coincided with the re-emergence of more experienced and sophisticated hedge fund investors within the endowment, foundation, large family office and fund of fund sectors of the market.  Many of these experienced investors believe that the largest hedge fund managers have accumulated too many assets, which dilutes their alpha over a larger asset base and, more importantly, increases the investment risk to investors because of the larger bets they are required to make in individual securities.  In addition, a study conducted from 1996 through 2010 by Per Trac showed that small hedge funds consistently outperformed their larger peers.
 
This greater focus on smaller, more nimble managers will continue to gain momentum as some of the largest hedge funds have recently experienced significant publicity for the poor performance they have generated over the past year.  This is good news for small and mid-sized hedge fund managers that represent a majority of the firms in the industry. 
 
Continued concentration of hedge fund flows into a small percentage of managers with the strongest brands
 
In 2012 those hedge funds with the strongest brands will gain a vast majority of the net flows and can be divided into 3 main categories:  1. Hedge funds with over $5 billion in assets who have generated short and long-term performance above their peers  2. A few high profile start-ups that have spun out of prop trading desks from investment banking firms or well known hedge funds and finally,  3. Those small and mid-sized hedge funds that are able to rise above their peers by providing a high quality offering, clearly and concisely articulating  their differential advantage across all the evaluation factors investors use to select hedge funds and having a best-in-breed marketing strategy.
 
Increase in both hedge fund closures and launches
 
2012 will reverse a 3 year trend of declining hedge fund closures and will be driven by managers that significantly underperformed their peers in 2011 and suffered heavy redemptions.  It will also be aided by the loss of hope amongst many managers that have had difficulty raising assets 4 years in a row due to the high concentration of assets flows. This increase in fund closures will be offset by the 4th year in a row of an increased number of fund launches. 
 
More hedge funds focused on the retail market
 
As raising assets for hedge funds becomes increasingly more difficult many hedge funds are beginning to target the retail markets that are less competitive and easier to raise assets from.  In Europe we have seen the assets in UCITS funds expand significantly in 2011 with more growth expected in 2012.  In the US we are seeing a large growth in 40 Act hedge funds and hedge fund of funds, with many more expected in 2012.  We are also seeing hedge fund replication strategies utilizing ETFs.  All of these have their strengths and weaknesses and could create more regulatory scrutiny.  Significantly, the first movers into these markets have typically had a much easier time raising assets from these more retail oriented structures than from traditional hedge fund investors.
 
Greater hedge fund investor concentration risk due to more assets placed utilizing consultants
 
One of the questions hedge fund investors ask when performing due diligence on a hedge fund is, “how big is your largest client?”  The reason for this question is to understand the potential for business risk to the organization if the largest investor redeems.  In addition, investors are trying to determine if there could potentially be any implications relative to gates or suspended redemptions.  Finally, they are also concerned about the make-up of the underlying portfolio after a large redemption.  No investor wants to potentially be left with the toxic waste when many of the more liquid securities are liquidated to pay the redemption.  This used to be a simple question, but now it is much more complicated due to the explosive growth of assets placed utilizing investment consultants.  Many large institutional investors rely almost completely on their consultant’s advice when hiring and firing a hedge fund. Some hedge funds have a majority of their assets controlled by a couple of consulting firms.  Because the underling investors are not making independent decisions, a sell recommendation by a few consultants could have major implications for the hedge fund organization or its underlying portfolio.  This is especially an issue for less liquid strategies.
 
In conclusion, Agecroft Partners expects 2012 to be a very good year for raising assets in the hedge fund industry. This will we driven by a combination of positive net flow into the industry from most investor segments and large rotation of assets between managers. Although the competition from the largest well known funds will decline, the market place will remain highly competitive where a majority of assets will be going to a small percentage of managers. The managers that are successful growing their business will be those that rank well across multiple evaluation factors, have a high quality marketing message and strong distribution capabilities. The hedge fund industry is moving toward a period of sustained growth driven by institutional investors that will increasingly adopt a more institutionalised process for evaluating hedge fund managers.

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