By Don Steinbrugge, Founder and CEO, Agecroft Partners
Each year, Agecroft Partners predicts the top hedge fund industry trends through their contact with more than two thousand institutional investors and hundreds of hedge fund organizations. Given the hedge fund industry’s dynamic and constantly changing nature, it is crucial for firms to anticipate likely changes. Those that are able to adapt effectively to industry shifts will succeed, while stagnant firms will be left behind. Below are Agecroft’s 15th annual predictions for the most significant trends in the hedge fund industry for 2024:
- The hedge fund industry reaches maturity. The hedge fund industry has witnessed remarkable growth this century, surging from $265 billion in 2000 to surpassing $5 trillion, according to Statista. While a significant majority of hedge fund investors demonstrate steadfast long-term commitment to this asset class, many major investment entities—such as pension funds, endowment funds, foundations, sovereign wealth funds, OCIOs, private banks, and advisory firms—seem to have reached a saturation point in fully allocating a percent of assets to hedge funds. Consequently, the industry’s future growth will likely slow, with the primary expected growth stemming from performance at a 6% to 8% annual rate.
- 2024 will be a strong fundraising environment for top managers and strategies in high demand. Annually, there is substantial rotation of assets within the hedge fund industry, influenced by relative performance and shifting strategy preferences. We estimate that investors turn their portfolio over on average 20% per year, which in a $5 trillion dollar industry, would lead to $1 trillion of re-allocations each year. This turnover is impacted by several factors, including the dispersion of manager performance within a strategy, changes in relative valuations across markets, and future economic expectations. We expect higher than average turnover due to recent, significant performance dispersions observed among strategies and managers with similar styles. Underperforming managers are likely to face above-average redemptions, leading some to cease operations. Some of these redemptions will be allocated to better-performing managers within the same strategy, while most will flow into other strategies as investors reallocate their portfolios based on capital market valuations and economic forecasts. We identify five major themes for asset flows:
a. Long/short equity managers, particularly those focusing on small/mid-capitalization or value stocks. Over extended periods, the price/earnings multiples of equity indices typically mirror the expected growth rate of constituent companies’ earnings and the confidence level in earnings forecasts. Periodically, there are discrepancies in index valuations, but eventually, a reversion to the mean occurs. In the last decade, significant disparities in valuation multiples emerged between the S&P 500 and most small/mid-cap indices, as well as deep value stocks. This contrast became extreme, notably with the expanded valuations of the ‘magnificent 7’ that drove the S&P in 2024. Eventually, these disparities are expected to narrow. Long/short equity managers are poised to benefit in this environment, particularly those with moderate asset bases, providing them with the flexibility to take substantial positions in small and mid-sized companies or those focused on deep value stocks.
b. Private lending and specialty financing. These are strategies that have continued to attract an enormous amount of assets based on the concept that private debt securities offer a much higher yield spread over treasuries than traditional fixed income. These strategies tend to appear very promising during stable and rising markets; however, there is significant downside risk to many funds if a market selloff occurs.
c. Reinsurance. In 2023, numerous asset classes became more expensive due to the expansion of stock price-to-earnings (P/E) ratios and the contraction of credit spreads. Consequently, the reinsurance industry witnessed substantial price increases in 2023, leading to modeled returns, for comparable risk, more than doubling over the past 6 years. This uncorrelated strategy is expected to attract significant flows from large institutional investors
d. Market-neutral long/short equity managers. Broad valuation differences and fundamentals in the equity markets should allow more active managers to add alpha on both the long and short side of their portfolio, disproportionately benefiting market-neutral managers whose returns depend on alpha. Those with perceived information advantages or a focus on less efficient market areas are expected to attract substantial inflows.
e. If the economy enters a recession there will be a shift in investor demand. Strategies that will see more investor interest include distressed debt and uncorrelated strategies like commodity trading advisors (CTAs) and relative value managers.
- 3. Evolution in hedge fund fee structures for large institutional allocations. Fees have been a topic in the hedge fund industry for over a decade, and the industry is experiencing a bifurcation of fees. While 2 & 20 is no longer the norm, smaller investors are typically paying average fees of 1.5 & 20, while institutional investors are paying significantly lower fees, with an estimated average of 1 & 15—except for managers whose strategies are capacity-constrained or those who have enjoyed excess demand for their offering. Recognizing the importance of institutional clients, managers have structured discounted fees in three primary ways:
a. Schedules that tier fees based on the size of an allocation. This model has been standard practice in the long-only space for decades. It permits managers to avoid individual negotiations by reducing fees for larger allocations through a sliding-scale fee schedule available to all investors.
b. Tailored fees to address specific issues of prospective institutional investors. This involves give and take across multiple factors, including not only management and performance fees, but also performance hurdles, performance crystallization time frames, longer lock-ups, guaranteed capacity agreements, and potential revenue shares or ownership stakes in a management company in return for early stage investments.
c. Seeding and first loss. Seeding involves the manager sharing equity ownership of the firm, while first loss pays a higher performance fee but requires the manager to assume all losses.
- 4. Smaller managers expected to continue outperforming. On average, smaller managers have consistently delivered significantly better performance than larger managers. For instance, through November 2023, smaller funds outperformed larger funds over the past 1 year (4.52% vs 3.30%) and 5 years (5.91% vs 4.04%), as evidenced by the HFRI Fund weighted composite versus the HFRI dollar weighted composite. One of the major trends in the hedge fund industry has been the concentration of flows towards the largest managers with the strongest brands. Consequently, many of these managers have seen their assets swell well beyond the optimal level for maximizing returns for their investors. With increasing size, it becomes progressively harder to generate added value through security selection.
- 5. Pension funds are reducing the average size of managers to whom they allocate. As pensions struggle to enhance returns to meet their actuarial assumptions, we will also see an increase in the speed of the evolution of pension funds’ hedge fund investment process. Historically, many pension plans started with an investment in a hedge fund of funds, followed by hiring a hedge fund consultant and investing directly in typically the largest hedge funds with the strongest brands. As they increased their knowledge of the hedge fund industry and added to their internal research teams, they began making more independent decisions and focused on “alpha generators” which included mid-sized managers. Finally, many have added an emerging manager component to their portfolios to take advantage of capacity-constrained strategies, capture higher returns, or benefit from a larger fee break. This has required these funds to abandon any limitations they may have had on the percentage of assets they represent of a manager’s assets.
- 6. Virtual work and meetings for investors are here to stay. This trend offers industry professionals more flexibility in choosing their residence and reduces unproductive commuting time. Traveling is expensive, time-consuming, and tiring. To enhance efficiency, investors will increasingly conduct a majority of non-office meetings virtually, reserving in-person visits for their select list of top managers. Furthermore, since virtual meetings are often recorded, they can be easily shared with other members of the investment team or reviewed later. Investors have also noticed that senior members of hedge fund teams are more likely to participate in virtual meetings compared to in-person meetings held at investors’ offices. This trend will also apply to cap intro events, where investors can efficiently meet with a high number of quality managers over a short period of time.
- 7. Increased demand for managed accounts. A growing number of large investors are opting for individually managed separate accounts. They seek greater control over their assets, increased leverage, better management of expenses allocated to their accounts and enhanced transparency. Consequently, we anticipate more managers being inclined to handle separate accounts and a decline in the minimum required assets for such accounts.
- 8. Lower expected returns from private equity. With the lines between hedge funds and private equity funds narrowing, it is important to note that returns for private equity have been exceptionally strong over the past decade, leading to record flows into the industry. This trend has stretched valuations of many new deals. Some industry experts estimate that there is close to $2.5 trillion of undeployed capital by private equity funds, which should further increase valuations for new deals. Many private equity funds are illiquid, leveraged equity plays that entail significantly more risk than most investors perceive. With all of this cash competing for deals, we believe return expectations for private equity should be lowered while increasing the expected tail risk. Despite this, the market remains highly inefficient, and there are still some niche areas offering above-average returns.
- 9. Quality marketing plays a pivotal role in asset growth. The hedge fund industry is fiercely competitive, estimated to comprise around 15,000 hedge funds in the market. In 2024, we anticipate a further concentration of hedge fund flows, with a small percentage of managers likely attracting 90% of net assets within the industry. To succeed, it’s insufficient merely to offer a high-quality product with a strong track record. Being among the top 10% of hedge funds places a manager in an exclusive group of 1,500 funds. Hedge funds with superior products must also possess a best-in-class sales and marketing strategy that deeply penetrates the market and cultivates a high-quality brand. This demands a team of seasoned professionals capable of projecting a positive firm image. Achieving this can involve building an internal sales team, leveraging a leading third-party marketing firm, or a combination of both. We anticipated further industry consolidation, with fewer new hedge fund startups and more closures. Firms lacking a high-quality sales and marketing strategy may struggle to attract assets and face a higher probability of shutting down.
