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Hedge Funds

Preqin Special Report: The Future of Alternatives in 2027

In this article

Written by Sam Monfared, PhD, CFA, CAIA

October 5, 2022

Hedge funds are expected to feel the pain before recovering

The hedge funds industry is impacted by the current market environment, and as a result AUM growth is expected to slow over the next five-and-a-half years
Hedge funds have been around for decades. In fact, many consider the asset class to be the most mature among alternatives. The diversity of hedge fund strategies also means they have found their way into many portfolios. Investors gravitate towards hedge funds because they can produce attractive, risk-adjusted returns, as well as statistically significant alpha. What’s more, the asset class can also absorb negative shocks in the market and help investors manage risk in their portfolios. Together, these benefits have boosted the industry’s total AUM to $4.1tn as of June 2022 (Fig. 4.3). This closely tracks private equity, which posted AUM of $4.6tn as of December 2021.

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Before we dive into the outputs of our analysis, it is important to point out that Preqin has developed a separate model just for hedge funds, and that the focus of this chapter is AUM growth. We forecast each of the four regions and the AUM for the entire market separately, using the Holt-Winters method. Next, the AUM forecasts are rescaled for each forecasted horizon and region.

The model:

(A) is a linear, additive trend, and dampened over time;
(B) assigns higher weights to more recent observations, and
(C) takes into account the additive quarterly patterns.

Point (A) guarantees that the model is robust, conservative, and allows for market saturation. Point (B) allows us to capture momentum, and to weight previous regimes lower according to relevance. Point (C) admits a conservative model of seasonality, which is likely present in the quarterly data. The model also delivers a forecast of the market aggregate, which is close to the aggregate of individual forecasts, and allows for 10% downside deviation.

Return to outflows dampen the global outlook

There is no question that hedge funds bailed many portfolios out when the COVID-19 crisis started (Fig. 4.1). This is not to say that hedge funds did not feel the pain in Q1 2020 (-10.59%)! They certainly did, yet they performed substantially better than public options (Fig. 4.2). During the quarter, US large cap equities (SPY, -19.45%), international developed equities (VEA, -23.99%), US high-yield bonds (JNK, -12.74%), international bonds (OIBAX, -16.88%), and the 60/40 proxy portfolio (AOR, -13.50%) all declined significantly. For two years after the Q1 2020 crash, hedge funds benefited from the V-shaped recovery and strongly participated as the market bounced back. Between Q1 2020 and Q1 2022, the industry returned +21.71% to investors on an annualized basis (+48.14% total). During those eight quarters, investors allocated an additional $46bn to the industry, and hedge funds experienced six quarters of inflows.
It is fair to say that hedge fund allocators are momentum investors. Outflows follow periods of major market pullbacks, and vice versa. So the rate hikes of Q2 2022, along with geopolitical tensions and the war in Ukraine, put significant pressure on markets and forced investors to revisit their allocations. It is important to point out that, despite all the pressure in Q2 2022, hedge funds (-7.54%) still performed better than the 60/40 proxy portfolio (-10.80%). However, this wasn’t enough to prevent investors from withdrawing their capital, and the industry experienced its first significant outflow during Q2 2022 (-$32bn).

Our view is that the industry will experience more outflows and pullbacks before bouncing back. The US Federal Reserve has already increased rates substantially, as have the BoE (Bank of England) and ECB (European Central Bank). Based on the guidance given by central banks, further rate hikes are expected over the next 12 months. This means additional volatility and potential declines — especially if the global economy enters a recession in the second half of 2022 or the first half of 2023. As mentioned in the previous section, our model allows for a 10% downside to capture this potential downturn in the market. We expect global hedge funds AUM to reach $5.0tn post-recovery by the end of 2027 (Fig. 4.3). This translates to a +3.45% growth rate on an annualized basis from June 2022 (Fig. 4.4).
To put this into perspective, the industry grew by +3.39% from the end of 2014 to 2018 on an annualized basis, and by 7.94% annualized between 2018 and 2021. The annualized growth of the asset class between 2014 and H1 2022 was 4.31%. Undoubtedly, the current environment will have a negative impact on the industry in the short term before we see a recovery. But investors need to remember that hedge funds benefit from market stress, which causes dislocations in the market. This leads us to believe that their risk-adjusted performance will be comparable to previous periods. The strategies that are expected to benefit most from this environment in the near term are macro strategies, CTAs, and relative value strategies.

We note that interest in alternative assets has grown, which has benefited private capital more than hedge funds. We expect this trend to continue over the coming years. But this does not suggest that hedge funds are no longer needed in portfolios. It simply means that allocators are diversifying their portfolios by investing in a variety of risk buckets.

North America funds outperform those in Europe

North America is the home of the hedge funds industry, with 80.4% of the total industry AUM focused there ($3.3tn as of June 2022). Funds focused on the region (+8.55%) have greatly outperformed hedge funds focused on Europe (+3.50%), and APAC (+6.90%) over the five years ending June 2022 (Fig. 4.5). However, in Q1 2020 North America-focused funds declined by 11.58%, in line with Europe’s (-12.57%) and APAC’s (-10.24%) respective drops that quarter. Following that, between Q1 2020 and Q1 2022, North America-focused funds (+26.07%, annualized) significantly outperformed Europe (+15.25%, annualized) and APAC (+19.22%, annualized), keeping investors happy. Things changed in Q2 2022, a rough quarter for North America-focused hedge funds (-8.82%), relative to those focused on Europe (-5.78%), and Asia-Pacific (-4.45%), although the H1 2022 return (-10.94%) was similar to other regions.
To measure the risk and return performance of a portfolio, we use both Omega and Sharpe ratios.

1. The Omega ratio (a risk/return performance measure) is the probability-weighted ratio of gains over losses for a given minimum acceptable return (0% in this case).

2. While the Omega ratio considers all moments (mean, volatility, skewness, and kurtosis) by design, the Sharpe ratio considers only the first two moments (mean and volatility) of the return distribution. In a sense, therefore, Omega is a more reliable measure than Sharpe.

Funds focused on North America have the highest Omega (2.06) score, outperforming other regions on a risk-adjusted basis. Running the North America-focused benchmark against Carhart factors (Fama-French & Momentum)[1] reveals that hedge funds have produced statistically significant alpha (+4.14%) over the past five years (ending June 2022), with +0.45 beta (market risk premia factor loading).

As observed above, this strong regional performance has prompted inflows. Investors allocated an additional +$53bn in 2021, and $42bn in H1 2022 to hedge funds based in North America—the only region with positive inflows across both years. Despite this, AUM declined by 3.4% during H1 2022, and we expect further declines in AUM due to outflows and market conditions in the short term before the region’s assets rebound. The rebound will likely start when allocators realize that the Federal Reserve no longer needs to increase rates and will soon reduce them, which would show investors that it is time to reallocate.

Based on our analysis, North America-based hedge funds are expected to grow by +3.85% on an annualized basis between H1 2022 and 2027 to constitute 82.2% of the total AUM. The nature of our model means this is a conservative estimate. For context, funds based in the region grew by +4.47% from the end of 2014 to 2018, and by +9.58% between 2018 and 2021 on an annualized basis. Overall, the annualized growth of the asset class between 2014 and H1 2022 was 5.70%. The other factor to keep in mind is the relative maturity of the hedge funds industry, and that North America has long been the industry’s base. This leads us to expect modest regional growth compared with what was experienced between 2018 and 2021.

European funds losing ground

Europe-based managers ($626bn) account for 15.1% of total AUM as of June 2022. This is noticeably lower than the 20.2% of total AUM held by regional managers in December 2014. Comparatively less attractive regional performance has prompted outflows of $113bn since the beginning of 2015 to H1 2022 — more than any other region.

Recent performance has certainly been disappointing. Hedge funds focused on the region have returned +3.5% on an annualized basis to investors over the past five years (ending June 2022), with a 7.70% standard deviation. Europe’s risk-adjusted performance, as measured by Omega (1.53), is also below other regions, and managers in Europe have also failed to produce statistically significant alpha in aggregate. This is not to say there are no quality hedge fund managers in Europe. But it does suggest that Europe as a whole has failed to remain competitive compared with North America and the APAC region. For instance, funds focused on the region experienced the most pull back (-12.57%) in Q1 2020 and participated least in the recovery (+15.25%, annualized) between Q1 2020 and Q1 2022 compared with North America-focused (26.07%) and APAC-focused (19.22%) funds. All these factors have influenced the way allocators view European hedge funds.

H1 2022 was rough for the industry. Europe-based hedge funds experienced an 8.8% decline in AUM and based on our forecast, the region will grow by +1.97% on an annualized basis between H2 2022 and 2027 to reach $697bn, which broadly aligns with historical growth. To put this in perspective, funds based in the region grew by +2.30% from the end of 2014 to 2018, and by +0.97% between 2018 and 2021 on an annualized basis; this brings the CAGR for the entire period between 2014 and H1 2022 CAGR to +0.38%. High inflation and the ECB’s rush to control higher prices through monetary policy leads us to believe that the region has not yet reached the bottom. Therefore, we expect additional declines in hedge fund AUM before we see a recovery.

APAC funds struggle for traction

APAC has performed exceptionally well in recent years. Despite this, APAC-based hedge funds ($154bn) account for just a small portion of total global AUM (3.7% as of June 2022). Managers focused on the region have returned +6.90% to investors over the past five years, ending June 2022. These managers experienced the lowest drop (-10.24%) in Q1 2020 compared with other regions (North America: -11.58%, Europe: -12.57%); participated sharply in the two-year recovery during COVID-19 between Q1 2020 and Q1 2022 (+19.22%, annualized); and experienced the smallest pull back in Q2 2022 (-4.45%) relative to North America (-8.82%) and Europe (-5.78%). Not only that, but sentiment towards APAC has changed for the better in 2020 and the first half of 2021. China — the biggest economy in the region — has tried to open its markets to foreign investors in recent years, but the 2021 tech crackdown and geopolitical tensions have scared some international investors away.

The industry is certainly establishing its position in the region, but in terms of allocations, it is still behind others. As we observe in the 2022 Preqin Global Hedge Fund Report,[2] the median allocation towards hedge funds in APAC is 5.9%, which is substantially lower than North America (9.1%). Greater China, excluding Hong Kong, has a median allocation of 1.5% and Hong Kong’s and Australia’s median allocation is 5.9%.

The low allocations toward hedge funds and outflows (-$59bn) from the beginning of 2015 to H1 2022 resulted in mediocre growth (+0.77%, annualized) during the interval. Based on our forecast, the region will grow by +1.02% between H1 2022 and 2027 on an annualized basis to reach $162bn in AUM. As with other regions, we expect further decline before a comeback. Geopolitical tensions are far from over and recessionary pressure is still very much present in the region, forcing the central banks to revise their monetary policies or instigate contingency plans. Even countries that usually do not have high inflation, such as Japan, are dealing with spikes in prices. Among major economies in the region, China is the only country that is cutting rates to help its real estate market and local economy.[3] It is fair to say that regional conflicts are also adding fuel to the fire in APAC. All these factors suggest that regional growth will be low as hedge funds are unlikely to become a major part of portfolios in APAC.

Rest of World off the radar

Hedge funds have not established a presence beyond the three main regions. Markets in most countries outside of North America, Europe, and APAC are less developed and, in many cases, not fully and/or safely open to foreign investors. These factors have resulted in $59bn of outflows from the beginning of 2015 to H1 2022, prompting substantial decline in AUM over recent years. From the end of 2014 to 2018, ROW AUM declined by 15.94%, and the negative trend continued between 2018 and 2021 (-5.08%). We expect a -0.45% decline in ROW AUM on an annualized basis between H1 2022 and 2027, suggesting the downward trend will persist—although at a lower rate.

In short

Preqin forecasts suggest that the annual rate of growth will slow in North America and APAC and will align with historical figures in Europe. Hedge funds will likely benefit from the dislocations that are currently forming in the market, but investors are cautious with their allocations in this environment. This leads us to believe that the industry will likely feel some short-term pain before seeing growth in the longer term.
[1] Fama, E.F. & French, K.R. (1993) Common risk factors in the returns on stocks and bonds. Journal
of financial economics, 33(1), 3-56.
[2] 2022 Preqin Global Hedge Fund Report
[3] China trims lending rates one week after surprise cuts in key rates