By Don Steinbrugge, Founder & CEO, Agecroft Partners

Here are Agecroft Partners’ 14th annual predictions for the biggest trends in the hedge fund industry for 2023. These predictions are based on dialogue with more than 2,000 institutional investors located globally and hundreds of hedge fund organizations. They are also predicated upon an economic forecast of continued rising interest rates for at least the 1^st half of 2023 and a moderate recession. The hedge fund industry is dynamic and both managers and investors can benefit from anticipating, and preparing for, the changes likely to occur.

1. Increase in expected returns for a diversified hedge fund portfolio. With the risk free rate projected to rise above 4%, from close to 0% last year, investor return expectations for a diversified hedge fund portfolio will also increase from the mid-single digits to 7-9% during a period of continued headwinds for the capital markets. Higher rates will have a dramatic impact on the relative demand for  some hedge fund strategies as investors focus on the expected returns above the risk free rate for each strategy driven by beta (the underlying markets the strategy focuses on) and alpha (created through manager skill). This will reduce demand for those high Sharpe Ratio, low volatility strategies whose annualized returns fall below the required return minimum hurdle.

2. Increase in demand for strategies with excess collateral. Most people associate rising interest rates with declining asset values. In fixed income markets, there is an inverse relationship between interest rates and bond values. This relationship can also apply to equity valuations. For the many investors who believe that the underlying value of a company is the present value of its future earnings, discounting those earnings at higher rates results in lower valuations. In contrast, rising short term rates can have a positive impact for hedge fund strategies that hold large cash/short-term fixed income positions. This helps maintain consistent returns over the risk free rate over time. Examples of hedge fund strategies that hold a lot of cash/short-term fixed income positions include:

1. Commodity Trading Advisors (CTAs). CTAs take positions in commodities, currencies, equity indexes, and interest rates through the futures market. The inherent leveraged structure of these instruments results in many CTAs deploying only 10-20% of their capital. The balance is held as collateral and allocated to short-term fixed income positions.

3. Reinsurance. Reinsurance hedge funds are required to be fully capitalized for all potential liabilities/claims they may incur.  The fund capital is held as collateral and typically invested in very short-term, highly rated securities.
4. Market Neutral Long Short Equity. A manager with a 100% long and a 100% short exposure will have a gross exposure of 200% and a net exposure of 0%. Funds received from securities sold short are simultaneously posted as collateral against the securities borrowed to deliver against the sale. The return on that cash collateral (the “short rebate”) is tied to short-term fixed income rates with the exception of hard to borrow stocks. It is important to note that some of the increased yield will be kept by the prime broker and not passed to the manager.

3. Redefining risk. With interest rates expected to continue rising coupled with a moderate recession in 2023, the probability of performance tail risk increases. This will cause many investors to redefine how they view and measure risk. Historically, many institutional investors sought to maximize expected risk-adjusted returns for a multi-asset class portfolio. Calculations to determine optimal asset allocations require assumptions for return and volatility for each asset class as well as the correlations across asset classes. These assumptions are based on a combination of long-term historical returns, current valuation levels, and economic forecasts. Together, these variables can be applied to optimization models and help determine the asset allocation with the highest expected return for a given level of volatility.

Unfortunately, these models have subjected portfolios to significantly greater risk than anticipated. Typically, when markets sell off substantially, both volatility and correlations across asset classes increase dramatically resulting in larger than expected portfolio losses. The true risk of a portfolio is better measured by understanding how the volatility and correlations of each of the underlying strategies will change during market sell-offs. Doing so will more accurately forecast the impact of a sell-off  on the overall portfolio. As a practical matter, most strategies are short volatility, and less liquid strategies tend to have the greatest tail risk. These strategies also typically have low volatility and high sharpe ratios simply because they do not mark-to-market their portfolio.

4. Greater alpha due to higher volatility. The capital markets experienced a large increase in volatility in 2022 due to economic and political uncertainty, which we expect to continue throughout 2023. This should make it easier for managers to outperform passive benchmarks as larger price movements help skilled hedge fund managers add value through security selection. As valuations reach price targets more quickly, managers are able to capture gains and reinvest capital in other opportunities more frequently. This should particularly benefit long/short equity managers, especially those that focus on small and mid-capitalization stocks. Small cap stocks are currently trading at extreme discounts compared to their large cap peers and are also a less efficiently priced segment of the market due to limited sell-side analyst coverage.

5. Continued high concentration of net flows going to a small percentage of managers with the strongest brands. Competition within the hedge fund industry increases each year, with an estimated 15,000 hedge funds in the marketplace. Hedge fund allocators are overwhelmed with the volume of incoming emails, calls and invitations to webinars and conferences. This makes it increasingly difficult to get a meeting with an investor, let alone a response. Some estimates suggest that hedge fund managers only receive responses on 15% of requests sent to potential investors, unless they have a strong pre-existing relationship.

As a result, we expect 5% of hedge fund organizations, with the strongest brands, to attract 80-90% of net flows within the industry. In order to successfully attract investors, it is not enough to have a high quality product offering with a strong track record. Ranking among the top 10% of hedge funds by performance puts a manager in an exclusive group of 1,500 funds. Managers must then differentiate themselves in order to successfully raise assets by having a strong brand. Firms with the strongest brand include the largest managers in the industry and a limited group of small to mid-sized managers who excel by offering a high quality investment product, clearly articulating their differential advantage, and implementing a best-in-class distribution strategy that deeply penetrates the market.

6. Smaller managers will outperform. As mentioned, one of the biggest issues within the hedge fund industry is the high concentration of flows to the largest managers with the strongest brands. This has caused many of these managers’ assets to inflate well past the optimal asset level at which they can maximize returns for their investors. As they become larger, it is increasingly difficult to add value through security selection. Although large managers outperformed in 2022, this was an aberration from what the industry has experienced long term. Small and mid-sized managers have a competitive advantage in being nimble and are able to generate meaningful alpha from less efficiently priced areas of the marketplace.

7. Decline in the number of hedge fund organizations. The hedge fund industry is Darwinian and constantly evolving. Due to an increasingly competitive environment, we expect the industry to consolidate with fewer new hedge fund startups and more hedge fund closings. This will impact some large, established managers as well as many small to mid-sized managers.  Some prominent managers’ strategies may no longer offer the alpha generating opportunities that historically drove performance and inflows. Managers with less than $250 million in assets, which represent a majority of hedge funds, are being squeezed from both the expense and revenue sides of their businesses.  As a result, we expect the closure rate to continue to rise for small and mid-sized hedge funds. No matter the size or tenure of the fund, poor performance will accelerate the outflows of capital and in some cases result in fund closures.

8. Blockchain technology. Many people have lost faith in cryptocurrencies due to high profile theft, fraud, and bankruptcies within the industry, which has caused pricing to implode. We expect modest, if any, asset flows to this sector in 2023, but remain bullish long term. The industry is still in its infancy and will continue to experience tremendous innovation, evolution, and exponential growth over the next decade. There are currently over 1,000 cryptocurrencies along with numerous service providers in the industry. The potential and investment opportunities in blockchain technology goes well beyond cryptocurrencies alone.  Individuals who can effectively evaluate the landscape, understand how the marketplace is evolving, and determine who will be the future leaders in the industry will be highly successful. Hedge funds will play a much larger role in the industry once security and operational issues improve, correlations between cryptocurrencies and other asset classes decouple, and as future markets are expanded to other blockchain opportunities.