Hedge Fund Assets Seen Growing by Quarter Trillion in One Year

In just one year the hedge fund industry’s assets under management are expected to climb by a quarter trillion dollars.

Yes, that was a quarter trillion.

Agecroft Partners, a third party hedge fund marketing firm, said in a recent update that despite funds underperforming the S&P 500 index, assets continue to flow into the sector.

Don Steinbrugge, managing director at Agecroft, said that there has been a constant flow of negative stories about the hedge fund industry over the past couple years including the insider trading scandals, hedge fund fees being too high, hedge fund performance comparing badly versus the S&P 500 index, and CalPERS divesting of hedge funds.

“However, contrary to these stories, eVestment recently reported that 2Q 2015 hedge fund asset inflows were the 2nd strongest quarterly inflows since the third quarter of 2009, bringing total industry assets to a record $3.1 trillion,” Steinbrugge said. “In addition, a recent industry survey by Credit Suisse Capital showed that 93% of institutional investors intend to increase or maintain their current hedge fund allocations in the second half of 2015.”

Agecroft Partners predicts, based on feedback from the thousands of hedge fund investors they are in contact with on a regular basis, that the hedge fund industry will be over a quarter trillion dollars larger by the summer of 2016. Over the past few years, the feedback they have received from the hedge fund investor community has consistently been very favorable towards hedge funds across investor types. This even included pension funds immediately after CalPERS announced disinvestment.

“Not only did the pension fund community not follow CalPERS lead, many of them did the opposite and increased their allocations to hedge funds.”

Steinbrugge’s prediction for growth is based on a combination of “net of fees” performance across the hedge fund industry and net flows into the industry. Based on current capital market valuations they believe the hedge fund industry will generate a 6% average rate of return over the next 12 months, which will account for over $180 billion in increased assets for the industry. This 6% expected return is lower than what the highest quality hedge funds will generate, because the industry average performance is impacted by an estimated 15 thousand competitors with a majority not worth the fees they charge. Significantly higher returns can be achieved by those hedge fund investors who are skilled at selecting the highest quality managers.

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Agecroft also predicts that net flows into the hedge fund industry will add another $100 billion in assets, and when combined with the $180 billion in assets from performance gains, will increase the industry by $280 billion.

“This prediction raises the questions: Where is the disconnect between the stories in the main stream media, and the attitude and behavior of many of the most highly sophisticated institutional investors who are responsible for a majority of the assets flowing into the hedge fund industry,” Steinbrugge asked.

He explained that institutional investors are not using the performance of the S&P 500 as a benchmark for their diversified multi-strategy hedge fund portfolio because hedge funds are not an investment asset class. Rather, they are a legal structure that represents a highly divergent group of strategies, many of which have little to no equity exposure. Comparing the average hedge fund to the S&P 500 is similar to comparing the average mutual fund to the S&P 500.

“Investors don’t compare Vanguard’s money market funds, or PIMCO’s total return bond funds to the S&P 500 index for obvious reasons. So, why should anyone compare a hedge fund portfolio consisting of CTAs, global macro, structured credit, market neutral equity, distressed debt, event driven, volatility strategies, and long/short credit managers with the S&P 500,” he asked. “This brings us to the question of why are institutions increasing their hedge fund allocation, and what are they using to determine if they are happy with their performance?”

Typically, pension funds meet annually to determine what their asset allocation should be going forward. For each component of their asset allocation, they forecast an expected return, volatility, and correlation, and compare these with other components in the portfolio. These assumptions are based on a combination of long term historical returns for an asset class, current valuation levels, and economic expectations. Once all assumptions are determined, these variables are run through an asset allocation optimization model to determine the optimal asset allocation with the highest expected return for a given level of volatility. A diversified hedge fund portfolio adds value to these portfolios in several ways. They have a low correlation to long only benchmarks, which can improve portfolio diversification and potentially provide downside protection during a market selloff. Many of these large institutional investors still have memories of the massive market value losses they sustained during the 2008 sell-off. Most important is their ability to enhance the forward looking return assumptions of the overall portfolio. Most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds. This compares very favorably to core fixed income, where the expected return is only 2.5% to 3.0%. As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.

These hedge fund asset projections are good news for the hedge fund industry as a whole; Steinbregge continued. However, it will primarily benefit a small fraction of the industry. A vast majority of the assets will continue to flow to the largest hedge funds with the strongest brands. Less than 10% of assets will flow to small and mid-sized hedge funds, which represent a majority of funds in the industry, despite historical studies that show that these managers outperform their larger competitors. Investment performance tends to be much less important than most hedge fund managers realize. Performance is used as a screen to narrow down the list of managers. However, the 10% of assets going to small and mid-sized hedge funds will primarily be directed to the few funds that excel at providing a high quality offering, clearly articulate their differential advantages across each of the evaluation factors investors use to select hedge funds and have a high quality distribution strategy.