New York (HedgeCo.net) – 2011 will be a very good year for flows into the hedge fund industry despite the recent negative publicity generated from the insider trading scandal, according to hedge fund consulting specialist Don Steinbrugge, Chairman at Agecroft Partners.
“This conclusion is based on several dominant and emerging trends identified through conversations with more than 300 hedge fund organizations and 1,500 institutional investors during 2010.” Stienbrugge said.
These trends include: 1. decreased competition from large prominent hedge funds: 2. improvement of capital flows across most major hedge fund investor segments including endowments, foundations and hedge fund of funds: 3. large increase in hedge fund launches: 4. increased allocations to small and medium sized hedge funds: and 5 increased importance of high quality marketing. These trends are explained below.
Decreased competition from large prominent hedge funds
In 2009 and 2010 there was a significant increase in competition within the hedge fund industry due to many previously closed hedge funds opening their funds to new assets. There were two primary reasons for this competitive increase. First, managers wanted to replace assets which had redeemed after the 4th quarter of 2008. Second, many of these high profile managers were below their high water mark and they needed new assets to generate fees in order to pay and keep their people. After two years of the majority of assets flowing to the largest hedge funds combined with strong performance, many of these big funds have either closed or are near capacity. Of the large hedge funds that aren’t yet closed, many either have issues or are gathering assets dilutive to their returns. The end result is less competition for assets from the largest well known hedge funds as investors shift their focus away from investing in brand names toward managers capable of generating future alpha.
Improvement of capital flows across most major hedge fund investor segments including endowments, foundations and hedge fund of funds
2010 saw the hedge fund industry approach its all time high for assets. This was primarily driven by a gradual yet substantial increase in allocations made by pension funds looking to enhance their risk adjusted returns and decrease their unfunded liability. This trend will continue throughout 2011 as we see an increase in the number of pension funds allocating to hedge funds as well as an increase in the percentage of their portfolio asset allocation to hedge funds. Pension funds will continue their evolution in how they achieve their hedge fund exposure. This process begins with an investment in fund of funds, followed by investing directly in brand name hedge funds, then focusing on alpha generators and finally changing to the endowment fund model of “best in breed” hedge fund investing.
Agecroft believes 2011 will see the return of many hedge fund investor segments that have been primarily on the sidelines the past two years. Some of these segments are reviewed below:
1. Endowments and Foundations: The endowment and foundation space is a bifurcated market comprised of organizations with more than $1B AUM and those with less than $1B AUM. Many of the larger endowments and foundations experienced significant liquidity issues within their portfolios as the expected duration of their private equity portfolios lengthened after 4th quarter 2008. These liquidity issues greatly reduced hedge fund allocations from this market segment over the past two years. Most of these liquidity issues have now been resolved and as a result we will see a significant increase in hedge fund allocations by large endowments and foundations in 2011. This will especially benefit mid-sized hedge funds as these sophisticated investors tend to have a bias against the largest hedge funds. For endowments and foundations with less than $1B AUM, 2010 provided an opportunity to increase their average portfolio allocations to hedge funds. We expect this trend to continue in 2011 as these mid-sized endowments move closer to the allocations of their larger peers.
2. Hedge Fund of Funds: 2009 and 2010 saw significant contraction in the number of hedge fund of funds as many ceased operations due to 1. Madoff exposure, 2. poor performance 3. strategic decisions by a parent company 4. lack of profitability, or 5. acquisition by larger competitors. In addition, a majority of assets flowed to a small number of the largest hedge fund of funds managers, keeping most hedge fund of funds well below their asset peak. This dynamic significantly affected small and mid-sized hedge funds managers because the largest hedge fund of funds tend to allocate to the biggest hedge funds, due to the large amount of money they need to allocate. The balance of the hedge fund of funds marketplace,which typically prefers the small and mid-sized hedge funds, were not allocating because as their assets declined, instead of replacing under-performing managers with new managers, they simply ran more concentrated portfolios.
Agecroft expects these trends to reverse. Most of the flows into the hedge fund of funds industry have come from large institutional investors who have been more focused on the perceived security provided by the size of a firm and its infrastructure as opposed to pure performance. Many large institutions have invested in a number of hedge fund of funds in an attempt to diversify their exposure. They may not realize that many of these large hedge fund of funds have significant overlap of underlying managers and have underperformed their smaller peers. As large institutional investors continue to increase their knowledge of alternative investments they will begin to utilize a hub and spoke approach to hedge fund of funds investing. This approach involves a hub investment in one of the largest hedge fund of funds as the core hedge fund allocation, and spokes made up of niche hedge fund of funds that either focus on small to mid-sized managers or specific strategies like CTA/Global Macro, Credit or Long Short Equity.These strategy specific hedge fund of funds will also be utilized in other parts of institutional investor’s portfolios in addition to their hedge fund allocation.
This growth of niche hedge fund of funds will increase the number of hedge fund of funds while insuring a smaller percentage of assets flow to the largest hedge fund of funds. Likewise, as these smaller, niche hedge fund of funds see their assets stabilize and begin to grow, they will reduce the concentration of underlying managers and begin to allocate again to new hedge fund managers. This should result in small and mid-sized hedge fund managers being included in more searches.
3. Family Offices: This segment of the market place has experienced significant growth as more and more super high net worth families hire full-time staff to manage their assets. This growth has recently been fueled by fortunes made in the technology, private equity and hedge fund industries. Many of these family offices prefer small and mid-sized managers who they view as more nimble and able to generate higher returns. Family offices will continue to be active allocators to hedge funds.
4. Consultants: The hedge fund consultant market place has seen explosive growth as more institutional investors and large family offices begin to invest directly in hedge funds. These consulting firms have seen their hedge funds asset under advisement balloon in size, which will eventually create difficulties for these firms in adding value to their client’s portfolios. 2011 will see continued growth in this industry with increased competition from new entrants into the marketplace from both traditional institutional consulting firms and hedge fund of funds organizations creating customized,separately managed portfolios for large institutional investors.
Large increase in hedge fund launches
The number of hedge fund launches steadily declined over the past two years as asset flows for start up managers slowed to a trickle. This created pent up demand for mangers wanting to launch a new fund, but waiting for improved market conditions before starting their new venture. With improved asset flows across most major hedge fund investor segments, many of these managers will have the confidence to finally launch their new funds. This will make 2011 the best year for hedge fund launches since 2007. This activity will be further fueled by leading financial institutions shedding their proprietary trading desks resulting in multiple, billion dollar hedge fund launches.
Increased allocations to medium and small hedge funds
2009 and 2010 were devastating for small and medium sized hedge funds. Even though these managers represent 95% of the number of hedge funds, they were only able to attract a small fraction of new hedge fund allocations. This despite the fact a study conducted from 1996 through 2009 by Per Trac showed that small hedge funds outperformed their larger peers 13 of the past 14 years. Unable to attract new assets, these small and mid-sizedhedge fund organizations feared the industry was in a new paradigm making it almost impossible to raise assets going forward. Agecroft believes thata much larger percentage of assets will flow to small and mid-sized managers due to the many strong trends leading into 2011 discussed here. These trends include less competition from the large, well known hedge fund managers, as well as increased allocations from endowments, foundations and hedge fund of funds. These investors tend to focus more on alpha generators than brand name hedge funds. In addition, we will see some of the more sophisticated pension funds allocating to small and medium sized hedge funds.
Continued importance of high quality marketing
Although a larger percent of assets will be allocated to small and medium sized hedge funds, the days of posting performance numbers to hedge fund databases and waiting for the assets to come are over. The market remains highly competitive with approximately ten thousand hedge fund managers. The typical institutional investor utilizes a process of elimination in selecting hedge funds where they are contacted by thousands of investment firms a year, meet with a couple hundred and ultimately hire half a dozen. Their due diligence process is longer, more focused and deeper than ever before. Institutional investors typically require three to five meetings before making an investment decision. Their process focuses on multiple evaluation factors including: 1. organizational quality, 2. investment team, 3. investment process, 4. risk controls, 5. operational infrastructure, 6. terms and 7. historical performance. A perceived weakness in any of these factors will eliminate a firm from consideration. As a result, hedge fund managers need to not only have a well refined marketing message that effectively articulates their differential advantages over their competition, but also a professional, proactive and knowledgeable sales force able to deeply penetrate the market place and stay involved with investors throughout their lengthy due diligence process. This is very difficult for a single salesperson to achieve. As a result, we will continue to see hedge funds building out their sales teams and leveraging third party marketing firms to expand their distribution efforts.
In conclusion, Agecroft Partners expects 2011 to be a strong year for flows into the hedge fund industry. Although the competition from the largest, well known funds will decline, the market place will remain highly competitive where a majority of assets will be going to a small percentage of managers. The managers that are successful growing their business will be those that rank well across multiple evaluation factors, have a high quality marketing message and strong distribution capabilities. The hedge fund industry is moving toward a period of sustained growth driven by institutional investors that will increasingly adopt a more institutionalized process for evaluating hedge fund managers.
About the author
Don Steinbrugge is Chairman of Agecroft Partners, a global consulting and third party marketing firm for hedge funds. Agecroft was selected 3 years in a row by a major industry organization as the top 3rd party marketing firm. Highlighting Don’s 26 years of experience in the investment management industry is having been the head of sales for both one of the world’s largest hedge fund organizations and institutional investment management firms. Don was a founding principal of Andor Capital Management, which at its peak was ranked as the 2nd largest hedge fund firm. Previous to Andor Capital, Don was a Head of Institutional Sales for Merrill Lynch Investment Managers and Head of Institutional Sales for NationsBank (now Bank of America Capital Management). Don is a member of the investment committee for multiple institutional investors and is a frequent speaker at industry conferences relative to trends with institutional investors and the hedge fund industry.
Editing by Alex Akesson
