The Future of Hedge Funds: Trends to Watch

By Amy Bensted Posted In: Alternative Investments, Drivers of Value, Economics, Future States, Portfolio Management

What do the next five years hold for hedge funds? We posed that question to more than 300 fund managers and 120 institutional investors in alternatives in mid-2018. Our survey and research revealed several fascinating trends.

1. No Longer the Largest Alternative Asset Class?

Based on the industry’s viewpoint and our proprietary data, we predict that the hedge fund industry will grow by 31% in the next five years, reaching $4.7 trillion in 2023. Although in percentage terms this is the smallest anticipated increase among all the alternative asset classes we track, at $1.1 trillion, it is the second highest level of projected net capital growth, behind only private equity ($1.8 trillion), which we expect to overtake hedge funds as the largest alternatives industry at $4.9 trillion.

2. More Exposure to Illiquid Strategies

Of private equity investors surveyed, 79% expect to increase their allocations to private equity by 2023, but just 27% of hedge fund investors expect to do likewise with hedge funds. Indeed, 16% anticipate decreasing their hedge fund allocations. Although the anticipated growth is not especially sizeable, neither is the percentage intending to shrink their allocations. As such, we foresee steady growth as most plan to keep their level of hedge fund exposure relatively stable, supporting the trend we have seen in recent years.

3. Modest Growth in Hedge Fund Allocations: Not All Bad News

Given the strong returns and record distributions in the private capital sector, it is little surprise that investors are beginning to shift towards illiquid alternatives in an attempt to further diversify and build out more sophisticated portfolios. However, the projections of comparatively modest growth in hedge fund allocations may not be as unfavorable 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, compared to 14%–15% for the average hedge fund investor. Though we expect hedge fund allocations 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.

4. Private Wealth: Coming Back Around?

Asked about the types of investors active in the industry, 76% of surveyed hedge fund managers predict that the share of capital they receive from institutions will increase. Notably, the largest cohort (66%) of respondents believe family offices will be more valuable sources of capital, followed by 52% who say foundations, and 46% who say 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, capital from high-net-worth individuals and families was critical. So it is interesting to observe how the industry appears to be coming full circle. After 15 years of institutional capital-fueled growth, there is now an expectation that the mass affluent will drive growth once again. To attract this capital, managers may need to adapt their product offerings to accommodate the different needs of these investors.

What does this all mean for hedge fund managers?

Despite rapid post-crisis growth in the number of managers, the total census of active hedge funds has plateaued since 2016. This coincides with a dramatic drop in new hedge fund managers entering the sector each year and across each region. There are around 14,800 active hedge funds today, a figure that has held steady since the end of 2017 and remains 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 between now and 2023, as cited by 91%, including 26% that anticipate significant levels of consolidation. This is the largest proportion among all alternative asset classes.

Consolidation and challenges lie ahead.

If our predictions prove true, 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, so too will the demands of these investors. We therefore believe that the environment ahead will present substantial challenges for hedge fund managers and that only those that can prove their value to investors and adapt to their changing demands will survive.

Despite the challenges, there is increased uptake from non-US investors.

As a region, North America has been the dominant source of hedge fund capital, but 42% of respondents in our study believe that the share of capital from North American investors will decline 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. Among emerging markets, the largest share of managers foresees an uptick in capital from the Middle East (37%) and China (29%).

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 local offices to accommodate a more regionally dynamic investor pool, expand their range of product offerings, or invest in new technology and approaches.

And technology may provide some answers.

When it comes to artificial intelligence (AI) and machine learning, 88% of managers surveyed predict these strategies will be of greater importance within the industry in 2023. When asked which area of their business stands to gain from advances in technology, the largest share (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 — remains to be seen, but the consensus is that these developments will improve efficiency in finding sources of alpha and reducing costs.

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

For more on alternative assets, don’t miss the Preqin/CFA Webinar: 2020 GIPS Standards for Alternative Investments.

Amy Bensted will be sharing more insights on the future of hedge funds and alternative assets at the 72nd CFA Institute Annual Conference from 12 to 15 May 2019 in London.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.