The Future of Hedge Funds

by Preqin

  • 23 Nov 2018
  • HF

A short while on from the Global Financial Crisis, which wiped out half of the hedge fund industry’s total assets, swathes of new investors in search of diversification and downside protection made their first investments in hedge funds, and those that made significant withdrawals during the Crisis began to ramp up their exposure once more. In 2014, total assets broke $3tn as the rush of new investors, spearheaded by pension funds from the US and Europe, set the industry on the path to institutionalization. Such demand from institutions meant hedge funds had to make significant changes to adapt, developing more robust infrastructure, deep back and middle offices and a wide network of supporting service providers.

More recently, many institutions have reached targeted exposure to hedge fund investments, and we have seen the amount of fresh capital from these groups begin to drop. However, with the increased adoption of UCITS and alternative mutual funds by managers to wrap their hedge fund strategies over the past decade, the industry has also become somewhat more democratized, and smaller investors have been able to access strategies otherwise out of their reach. This has resulted in the wider hedge fund sector growing as new sources of capital emerge. We have also seen the emergence of alternative risk premia strategies being offered by hedge funds and funds of hedge funds as an alternative to the traditional hedge fund strategy, with many investors shifting capital into these strategies in the past couple of years. Since Alfred Winslow Jones created the first hedge fund in 1949, the sector has shown continued evolution and innovation over the past 70 years, and is currently the largest alternative asset tracked by Preqin, with total assets standing at $3.6tn as at the end of Q3 2018.

So, what do the next five years hold for hedge funds? Based on surveys conducted at the mid-point of 2018 with over 300 fund managers and 120 institutional investors in alternatives, as well as our own proprietary data, Preqin predicts that the hedge fund industry will grow by 31% in the next five years, reaching $4.7tn in 2023. Although in percentage terms this is the smallest expected increase of all alternative asset classes, at $1.1tn this is the second highest level in terms of projected net capital growth, behind only private equity ($1.8tn) which is expected to overtake hedge funds to become the largest alternatives industry at $4.9tn.

In general, alternative asset investors are looking to ramp up their exposure to illiquid strategies over the next five years: for instance, 79% of private equity investors surveyed intend to increase their allocation to the asset class by 2023. Among hedge fund investors, however, just 27% expect to increase their allocations. At the other end of the spectrum, 16% expect their allocations to decrease by 2023. Although the anticipated level of growth in investor allocations is not sizeable, neither is the proportion intending to shrink their allocations, and so we foresee steady growth as the majority plan to keep their level of hedge fund exposure relatively stable, supporting the trend we have seen in recent years.

Given the strong returns and record distributions of recent years in the private capital sector, it is little surprise that investors are beginning to shift towards illiquid alternatives in an attempt to further their diversification efforts and build out more sophisticated portfolios. However, the projections of comparatively modest growth in hedge fund allocations may not be as unfavourable for the industry as the survey results suggest. Over the past decade or so, we have seen more and more investors build out increasingly large portfolios of hedge funds, with generally greater exposure to hedge funds than to private capital assets. For instance, private equity investors typically allocate around 9-10% of their portfolios to the asset class. The average investor in hedge funds, in comparison, has already amassed allocations of approximately 14-15%. Despite hedge fund allocations looking to remain relatively static across many institutional groups, there will likely be a large amount of activity, as investors continue to redeem and rebalance their holdings depending on market conditions and tactical objectives.

In terms of the types of investors active in the industry in the near future, 76% of managers surveyed predict that the share of capital they receive from institutions will increase over the next five years. Notably, the largest proportion (66%) of respondents believe family offices will be a more valuable source of capital over the next five years, followed by 52% for foundations and 46% for both sovereign wealth funds and endowment plans. These figures compare to 38% and 36% for private sector and public pension funds respectively. When we consider the private wealth origins of the hedge fund industry in the form of capital from high-net-worth individuals and families, it is interesting to observe how the industry appears to be coming full circle. After 15 years of growth fuelled by institutional capital, there is now an expectation that new growth will be driven by the mass affluent once again. To capture some of this, managers may therefore need to adapt their product offerings to accommodate the different needs of such investors.

What does this all mean for hedge fund managers, and how will they fare in the next five years? Despite rapid post-crisis growth in the number of managers in the industry, the total number of active hedge funds over time has plateaued from 2016, in tandem with a dramatic drop in new hedge fund managers established each year, across each region. As at the end of 2017 there are around 14,800 active hedge funds, which is relatively unchanged from the end of 2015. What will happen to this total in the next five years? Managers are largely united in the belief that there will be further consolidation in the industry in the next five years, as cited by 91%, including 26% that anticipate significant levels of consolidation. This is the largest proportion among all alternative asset classes.

On the basis that – if our predictions prove true – more capital ($1.1tn) will be flowing into the asset class over the next five years than over the last, and in line with the industry trends we have observed, we predict that the number of active hedge funds will either stabilize or shrink slightly over the next five years. As the ecosystem of investors evolves into something more and more complex, as do their demands. It is therefore our belief that the environment ahead will present substantial challenges for hedge fund managers to meet, and that only those that can prove their value to investors and adapt to their changing demands will survive.

But with challenges, there is always opportunity. Long the predominant region for hedge fund capital, 42% of respondents in our study believe that the share of capital received from investors in North America will decrease over the next five years as investors from other regions ramp up their exposure to hedge funds. In comparison, 64% and 59% predict that the share of capital from investors in Europe and Asia-Pacific respectively will increase by 2023. Within emerging markets, the largest proportions of managers foresee an uptake in capital from the Middle East (37%) and China (29%). Although investors in the traditional hedge fund hubs of the US and UK will remain vital sources of capital, the new opportunity opening up in regions such as the Middle East should present a new focus for managers in the coming years. We may well see a significant uptick in new office locations worldwide as managers try to capitalize on this increasingly global appetite for hedge funds.

How hedge fund managers adapt and evolve to meet the needs of a (likely) substantially different investor base will (more than likely) determine their success and longevity. Many may open up local offices to accommodate for a more regionally dynamic investor pool, expand their range of product offerings, or invest in new technology and approaches. Interestingly, 88% of managers surveyed predict that artificial intelligence/machine learning strategies will be of greater importance within the industry in 2023. When asked which area of their business could stand to gain from advances in technology over the next five years, the largest proportion (65%) of hedge fund managers cited fund operations. The measure of impact and the lifespan of new technology – such as blockchain, cryptocurrencies and big data as well as AI/machine learning – within the industry remains to be seen, but many are in agreement that such developments will improve efficiency in finding sources of alpha and help to reduce costs, and could therefore shape manager operations significantly.

In any area, however managers choose to evolve, it is surely the act of evolving that will make all the difference. The history of the hedge fund industry is evidence that a lot can change in just five years.

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