Average pension fund allocations to hedge funds over next five to 10 years ‘will reach 15 to 20%’, says Agecroft’s Steinbrugge
Net inflows to hedge funds could reach USD100billion this year – potentially the highest since they peaked at USD194billion in 2007 – with US pension funds likely to be the largest contributors. That’s opinion of Don Steinbrugge (pictured), Managing Partner of Richmond Virginia-based Agecroft Partners, a leading a third party marketing firm that specialises in hedge funds.
At the start of the year, Steinbrugge made a number of predictions for what might happen in the industry in 2012. These included: improved capital flows across most major hedge fund investor segments; large rotation of assets based on relative performance and changes in demand for strategies; increased flows to small- and mid-sized managers; continued concentration of flows to managers with the strongest ‘brands’; increased hedge fund closures and launches, and more retail-oriented hedge funds.
But it’s Steinbrugge’s capital raising outlook that intrigues. Last year was the second-worst performance-wise for global hedge funds so why the bullish sentiment, how realistic is it?
“I think it’s realistic. In 2007 it peaked at USD194billion, the second best year was ’06 (USD126billion) so as far as net flows go we’re not at the peak but they could be the best since 2007,” Steinbrugge tells Hedgeweek.
Steinbrugge bases his argument on the fact that pension funds need to generate a 7.5 per cent return annually and when they look at what their alternatives are…well, they’re not exactly great. “Consider long only fixed income. Right now the 10-year treasury is yielding below 2 per cent. They’ll be lucky to generate a 4 per cent return assuming interest rates don’t decline and give them a little bit of capital gain. If interest rates move in the opposite direction, fixed income could generate negative returns.”
As for equities, Steinbrugge says a lot of pension funds look back over the last 10 years and see that the equity markets have been close to flat. Last year, the markets were hit hard, particularly in Asia where the MSCI Asia Pacific Index ended the year down 18 per cent.
Despite the fact hedge funds were roiled by the markets in 2011, investors appear o be keeping faith, and if you believe Steinbrugge, will actually increase their allocations. “A lot of these pension funds are forecasting diversified portfolios of hedge funds to generate a 7.5 per cent return. That’s why I’m bullish. They’re not looking back one year and saying ‘Hedge funds did bad, let’s reduce our allocation’. They’re looking over a much longer period of time.”
This bullish sentiment is not a lone voice. Take Barclays Capital’s latest Money Trail report. They found that 56 per cent of surveyed investors planned to increase allocations in 2012 and that a potential USD80billion in net inflows could be seen, with an additional USD300billion being re-allocated across strategies.
Steinbrugge believes the industry is in the middle of a 10-year trend during which there’ll be both an increase in the number of pension funds allocating to hedgies, and an increase in the average percentage allocation. “If you compare pension funds to the largest US endowments, many of those are 50 per cent allocated to hedge funds. I don’t think pension funds will get to that level but I definitely think over the next five to 10 years we’ll see allocations of 15 to 20 per cent,” states Steinbrugge.
If true, that could add an additional USD300billion to USD500billion to total industry AUM.
It’s not only US pension funds that are under-allocated to hedge funds. According to the National Association of Pension Funds’ annual survey, UK pensions added USD12billion to hedge funds last year. Their allocation to hedge funds jumped to 4.1 per cent: a 50 per cent increase year-on-year. UK pension funds now have around USD33billion invested in hedge funds. Like the US, this number will likely increase going forward.
All of which should leave managers feeling more reassured as they lick their wounds from last year’s struggle.
Another of Steinbrugge’s predictions is that there will be a significant rotation of assets between managers. The media are perhaps guilty, on occasion, of over-exaggerating the redemption theme and net redemptions suddenly signal the demise of the industry. “It’s just a net number they’re communicating. What they don’t see is the redemptions leaving one hedge fund and going to another. I can’t quantify the number per se but what I can tell you is there’s a lot of money moving around.”
Steinbrugge thinks the way investors allocate across strategies has changed dramatically over the last four years. In his prediction piece he notes that equity hedge fund strategies totalled USD539billion (according to HFR data) in 2011 compared to USD684billion in 2007. Conversely, macro hedgies, including CTAs, have seen their AUM increase substantially from USD288billion in 2007 to USD434billion last year.
“I think this year you’re going to see continued strong demand for global macro funds, in particular CTAs. There are a number of things institutions like about CTAs: they’re not correlated with long-only benchmarks where most of their assets are allocated, they offer good liquidity and an investor can have a separately managed account. So that’s one area where we’re going to see a lot of money going,” explains Steinbrugge.
Another area of demand is likely to be structured credit, in particular strategies targeting mortgage-back securities. “Last year you saw spreads on non-agency mortgages widen out significantly due to technical reasons based on selling from European banks. I think there’s a lot of investors out there today who find the spreads very attractive in that part of the market,” adds Steinbrugge.
Steinbrugge also believes that Emerging Markets will continue to be favoured by investors, despite the fact that Asia ex-Japan LSE managers were down heavily in 2011: -14 per cent according to Eurekahedge. “A lot of those emerging markets have significantly greater growth in their economies than developed markets. In the develop world there’s been a situation where a lot of equity returns (or losses) have been driven by macro factors.”
“Bottom-up fundamental analysis hasn’t worked very well over the past two years but at some point, when valuations do matter, I think LSE managers will be able to generate significant alpha,” posits Steinbrugge.
As for who is likely to be successful at raising assets this year, Steinbrugge is pretty optimistic on small- and mid-sized fund managers’ chances, but even so, it’ll only be those with the strongest ‘brands’ that will succeed.
The definition of ‘brand’ has changed in Steinbrugge’s opinion. Not only is it confined to those managers with USD5billion plus in assets with long track records, or high profile managers that have spun out of prop trading desks, but also to small- and mid-sized managers.
Steinbrugge explains: “It’s really a three-part process. First, you have to have a strong product; second, you’ve got to be able to articulate your differential advantages effectively; third, you need a high quality marketing plan. For a mid-sized manager you have to have all three of those. If you only have a good product you’re probably not going to raise a lot of money.”
When asked whether pension funds realise that investing in the largest hedge fund managers doesn’t necessarily mean getting the best returns Steinbrugge responds: “I think pension funds are going through an evolution. They first start off using FoFs. The second step involves investing directly in big, well-known hedge funds. The third step focuses on what I would describe as alpha generators; your smaller managers. Not that many pension funds have evolved to this third step, but over time most of them will.”