In 2016, hedge fund investors' return expectations will trend lower, while industry assets reach a new high, according to Donald Steinbrugge, founder and managing partner of Agecroft Partners.
In a highly competitive marketplace, Steinbrugge says, hedge funds will need a high-quality sales and marketing strategy in order to raise assets.
For the seventh consecutive year, Agecroft, a hedge fund and consulting firm, predicts industry trends through its contact with some 2,000 institutional investors and hundreds of hedge fund firms.
Following are Agecroft's top 10 predictions for the biggest hedge fund industry trends in 2016.
1. Reduced Return Expectations
Hedge fund performance is driven by a combination of manager skill and market-driven returns — alpha and beta. From 2009 to the beginning of 2015, as both the fixed income and equity markets experienced strong bull markets, beta propelled hedge fund performance that rewarded managers with net long market exposure. Over this period, investors' return expectations for new managers steadily declined from the mid-teens in 2009 to just above 10% in 2014 and to mid-to-high single digits today. Agecroft says these reduced return expectations stem mainly from many investors' belief that beta will add very little value over the next few years as the capital markets trade near all-time highs.
2. Demand for Low-Correlation Strategies
Lower return expectations for hedge funds will strongly influence hedge fund strategy selection, according to Agecroft. Investors will perceive higher beta strategies as having higher—and unnecessary—risk. They will increasingly demand strategies such as relative value fixed income, market neutral long/short equity, CTAs, direct lending, volatility arbitrage, reinsurance and global macro, perceiving these as able to generate alpha regardless of market direction and as a hedge against a potential market sell-off.
3. Hedge Fund Assets to Reach All-Time High
Agecroft expects hedge fund industry assets to rise by $210 billion, or 7% (derived from a forecast of a 2% increase due to net positive asset flows and a 5% increase from performance), from an estimated $3 trillion today. It says this climb to a new all-time high will be fueled by pension funds reallocating assets out of long-only fixed income to enhance forward-looking return assumptions, and by other investors shifting some assets away from long-only equities to hedge against a potential market sell-off.
4. Smaller Managers Will Outperform
Smaller hedge funds, which often produce stronger performance than larger ones, should find the 2016 landscape particularly attractive, according to Agecroft. In moving to a performance environment increasingly dependent on alpha, security selection becomes ever more important, especially in less efficient markets where smaller managers have a distinct advantage over their bigger counterparts, many of which are past the optimal asset level to maximize returns for their investors. In addition, large fund managers, whose clients often are big pension funds run by risk-averse investment committees, have an incentive to reduce risk in their portfolios in order to maintain assets, and thereby increase the probability of continuing to collect large management fees.
5. Pension Funds Will Allocate to Smaller Managers
