By Don Steinbrugge, Founder and CEO, Agecroft Partners
The next 15 months will be the greatest asset raising environment in the history of the hedge fund industry and potentially a once-in-a-career opportunity for managers to grow assets. The strength of asset flows to managers will be much stronger than many industry professionals expect and potentially surpass $1 trillion. This should become clear as they consider these three factors that drive asset flows to managers: asset size of the hedge fund industry, manager turnover rate within investors’ portfolios, and net flows to the hedge fund industry. All of these point to record asset flows to hedge fund managers and are further described below:
1. Size of the hedge fund industry. BarclayHedge reported that hedge fund industry assets ended the 2nd quarter at an all-time high of more than $4.3 trillion. This is up seven-fold from approximately $600 billion at the turn of the century. Asset growth in the industry has been incredibly resilient, reaching new highs in 17 of the last 20 years. A majority of asset growth over the past decade is primarily attributable to compounding of industry assets due to positive performance and only a small amount came from positive net industry flows.
With limited net inflows of assets to the hedge fund industry, the size of the industry assets under management is an important driver of new asset flows to fund managers. Over the past 10 years, the hedge fund industry has been very Darwinian: Manager turnover within investors’ hedge fund portfolios hasbeen responsible for almost all new asset flows to managers. Holding net industry inflows and manager turnover constant, the higher the hedge fund industry assets, the more new assets will flow to managers.
2. Manager turnover rate within investor’s portfolios. There is a natural rate of manager turnover that fluctuates over time within the hedge fund industry and can have a massive impact on new asset flows to managers. For example, a 15% turnover rate of managers on $4.3 trillion in assets results in $645 billion in new asset flows to managers. If the turnover rate increases to 25%, nearly $1.1 trillion will flow to new managers. The manager turnover rate is typically driven by how investors perceive the relative quality of a manager versus others in their strategy, or by changes in target hedge fund strategy weightings within the portfolio. We expect manager turnover to reach an all-time high in calendar year 2022 due to pent-up demand, the large dispersion of returns among managers, and changes in hedge fund strategy preferences.
a. Pent-up demand to hire new managers. Covid 19 artificially reduced manager turnover. Coming into the pandemic, investors typically required an in person meeting with the hedge fund organization before making an allocation. Travel restrictions effectively cancelled all in-person meetings, thereby putting most new manager hires on hold for calendar year 2020. Assets placed during the year were significantly reduced. The allocations made were typically with managers the investor had met before Covid 19 or recommended by their investment consultant. During the first half of 2021, we have seen a growing, but still small, number of investors gain comfort in allocating to managers based solely on virtual meetings.
Although the resurgence of Covid caused by the Delta variant has slowed the opening of many offices, we expect travel to pick up throughout the 4th quarter with most offices opening by January 1st. This will significantly increase the pace and efficiency of both investment due diligence and operational due diligence on new managers. It will also be the strongest catalyst for achieving record levels of manager search activity, manager turnover, and flows to new managers in 2022.
b. Large dispersion of performance among managers. Over the past 18 months, we have seen a complete market cycle. The largest selloff in the capital markets since 2008 was followed by one of the strongest bull markets in history. This market volatility has led to a large dispersion of performance across managers within similar strategies and across strategies. The turnover rate of managers in investors’ portfolios is positively correlated with the level of dispersion in returns across managers. Simply put, if most managers’ performance is similar, few managers get terminated. When relative performance is widely dispersed, as was the case in 2020 and 2021, the rate of manager turnover increases significantly.
c. Changes in hedge fund strategy preference. The volatility in the capital markets over the past 18 months has also changed investors’ perception of relative values across the capital markets. This will influence investor preferences for hedge fund strategies and increase manager turnover. Allocations to less desirable strategies will be redeemed and the assets will be reallocated to managers in preferred strategies.
3. Net flows to the hedge fund industry. BarclayHedge reported positive net inflows during the past 12 months of $148.8 billion. This resurgence of net new investments follows a decade of nearly flat net flows to the hedge fund industry. We expect this recent trend to continue due to strong hedge fund industry performance, low interest rates and a two tiered fee structure benefiting large institutional investors.
a. Strong industry performance. After a long period of broadly lackluster results across the hedge fund industry, performance over the last 18 months has sparked renewed investor confidence. Hedge funds are typically added to investors’ portfolios to provide diversification and are expected to significantly outperform the capital markets during market selloffs. 2020 began with the largest selloff in the capital markets since 2008 and, for the most part, hedge fund performance met investor expectations. The modest drawdowns in the first quarter were followed by strong performance during the last 9 months of 2020. This resulted in the average hedge fund delivering net returns of almost 11% for the full year 2020. The first 6 months of 2021 saw hedge fund industry performance up approximately 10%, marking the strongest start to a year since 1999. Performance in 2020 and 2021 has led to growing investor confidence in the hedge fund industry and will help drive continued positive net industry flows.
b. Interest rates and credit spreads near all-time lows.Many large institutional investors evaluate the attractiveness of an asset class based on expected returns, volatility (risk) and correlation with other asset classes. Interest rates and credit spreads near all-time lows render fixed income strategies relatively less attractive. Interest rates cannot go much lower and credit spreads cannot get much tighter. As such, the negative correlation benefits typically anticipated from a “flight to quality” during equity market sell-offs will have limited positive effect on bond prices. The risk of owning fixed income has also increased, because the duration of bonds (sensitivity to interest rates) increases in low interest rate environments. Finally, return expectations in the mid 2% range make diversified fixed income portfolios less attractive to most public pension funds, whose actuarial rate of return assumptions are around 7%, and to endowments and foundations with payout ratios of 4% after allowing the fund assets to grow by the inflation rate. Many of these large institutional investors will continue to allocate away from low yielding fixed income investments to hedge fund strategies with higher expected returns and uncorrelated performance to the capital markets. Investors who do not view hedge funds as a separate asset class will invest part of their fixed income allocation to hedge fund strategies such as, distressed debt, specialty financing, structured credit, reinsurance and relative value fixed income among others.
c. Two tiered fee structure benefiting large institutional investors. High fees have historically been one of the biggest complaints about the hedge fund industry from large institutional investors. This fee pressure over the past decade has helped bring the average management fee down to 1.38% and performance fee down to 15.9% as reported by Eurekahedge. What typically is not mentioned, is the two tiered fee structure that has been adopted by the industry. Most hedge funds are willing to provide significant discounts to their standard fees to attract large institutional investors.
In addition to the volume of inflows at record levels for the hedge fund industry, we are also seeing many Hedge Funds no longer accepting assets. Based on data they received from Preqin, Bloomberg recently reported that a record 1144 hedge funds have closed to new money. Additionally, more than half of the largest multi manager funds, often referred to as multi-strategy, are no longer accepting new clients. This creates opportunities for new managers to fill the void.
What does all this mean to hedge fund managers? For managers seeking to raise assets and build new investor relationships, this may be a once in a career opportunity to do so. Most hedge fund managers have spent very few resources on travel or marketing over the past 18 months. Now is the time to use those resources to get in front of as many investors as possible. The most efficient way to do so is to participate in cap intro events hosted by both prime brokers and independent companies. Many of these will take place in January 2022 and managers who participate in multiple events will potentially have the opportunity to meet with more investors over a two-week period than they would be able to travel and see over the following six months.
This is not the time for managers to rely on posting their fund information and performance to industry databases and hope investors will come; very little new business comes from this strategy. Investors respond much better to a catalyst such as a cap intro event or in person meeting. Following the January cap intro events, hedge fund organizations should plan a heavy travel schedule for the first half of 2022. Once investors work through their pent up demand for new managers, we expect search activity to decline. This heavy travel schedule is also advisable for Managers that have had disappointing performance. To reduce the likelihood of redemptions, managers should be sure clients understand what drove the underperformance and are confident in the managers’ future performance.
