Hedge Fund Trends to Watch in 2019

5. Record Number of Established Hedge Funds Shutting Down

With some 15,000 funds, the hedge fund industry has become so competitive that managers resting on the laurels of previous years will struggle to retain assets. The increase in volatility in the capital markets in 2018 will magnify the dispersion in performance among those in similar strategies and accelerate redemptions for the underperformers, which have included celebrity managers. Many prominent managers with strong brand names and long, successful track records will need to reinvent themselves in the arms race for alpha. Those who do not should prepare themselves for outflows that could eventually result in the fund either closing or converting to a family office, as institutional investors are unlikely to give them the leeway they once did.

6. Growth of Advisory Business

According to Steinbrugge, an increasing number of consultants, advisors, multi-family offices, funds of funds and outsourced CIOs are moving away from commingling client assets into one fund, and adopting an advisory structure with portfolios customized for each client who will invest directly into a hedge fund. Although most of the client service for these accounts will be focused on the advising entity, this shift will burden hedge funds with the additional administrative costs of handling multiple accounts rather than just one commingled entity.

In order to attract this growing part of the market, hedge funds must respond to the unique needs of the advising entities, Steinbrugge says. This includes being flexible on account minimums and applying fee breaks based on cumulative assets across all accounts where applicable.

7. More Hedge Funds Offering Investors Co-investment Opportunities

Investors are often drawn to co-investment opportunities because they frequently include a fund's "best ideas," securities with less liquidity but greater return potential and lower fees. Compared to a limited partner investment in a hedge fund, managers typically find the costs of administering co-investments higher and revenues lower. Still, Steinbrugge notes, co-investments are a way for hedge fund managers to potentially participate in certain investments they might not otherwise have sufficient capital to access, at the same time adding to their asset base and generating incremental revenue.

8. Continued Growth of Applying Hurdles for Performance Fees

Fee pressure, which has been significant within the hedge fund industry in recent years, has been focused on the management fee, as most investors do not mind paying for performance, according to Steinbrugge. However, investors are increasingly differentiating between alpha-driven and beta-driven performance. A result is growing use of hurdles for performance, which vary from the risk-free rate to performance above an index for long-biased managers.

9. Greater Focus on Hedge Fund Expenses

Investors historically have not paid much attention to the overall expense ratio or which expenses the hedge fund has charged to the fund. No clear market standard exists for allocating expenses between hedge funds and the management firm, and some managers have been aggressive in allocating expenses to the fund, according to Steinbrugge. Watch for significantly more focus on this issue in light of recent changes to the U.S. tax code that limit the deductibility of fund expenses for taxable investors.

As investors and their advisors begin to address 2018 taxes, they will realize the extent to which these expenses are affecting net returns. "Toward the second half of 2019, we anticipate more investors will ask for information on funds' expense ratios and disclosure on the expenses being allocated to the fund. Over time we expect this will either reduce the expense allocation or increase the number of hedge fund managers applying a cap on fund expenses."

10. Enhanced Client Experience

Technology is being used to improve not only the investment process, but also client service. Hedge funds are making more information more accessible. Going forward, fund managers will use webinar technology to a greater extent for their quarterly and annual investor reviews, educational sessions and prospect meetings. Although video webinars are not quite as effective as face-to-face meetings, they can offer an element of communication and understanding gained through human interaction that can be easily lost via email or phone.

11. The Future Is Asia

Asian markets experienced broad-based decline in 2018, and demand for Asia-focused managers fell. "We remain sensitive to the political landscape and the potential near-term impact of trade policies by the U.S., China and other prominent global trading partners," says Steinbrugge. "Nonetheless, we believe that this declining trend will reverse, and that the reversal will be one of the strongest trends over the next decade."

He expects growth from both the investor and the hedge fund sides, noting that the International Monetary Fund reported last year that two-thirds of world economic growth over the next five years would come from Asia. At the same time, valuations of equities on several Asian markets trade significantly below valuation levels of European and U.S. markets. Many Asian markets are dominated by retail investors, creating pricing inefficiencies that are ripe for capture by hedge fund managers.

An enormous expansion of wealth is occurring in the growing Asian markets that will be looking for investment ideas to deploy their capital. Many U.S.-based hedge fund managers, whose global marketing strategy has been primarily focused on Canada, Switzerland and the U.K., will expand their horizons over the coming decade to the likes of Singapore, Hong Kong, Japan, Australia and Korea.