Hedge Fund Industry Maturing, Adapting as Investors Rebalance

Art by Harry Campbell

Special Coverage

Hedge funds as an asset class are making their presence felt in institutional portfolios again. But the industry itself is different now, and how investors view hedge funds has changed too.

In the 2010s, institutional investors put more of their capital into passive investments, and they were rewarded for it. But markets have changed. Rising interest rates, inflation and volatility have made it a better time for active management, and hedge fund performance has rebounded as a result. For investors taking a second look at the asset class, they are likely to find the same brand names, but some of the faces and structures have changed.

2023 has been a year of high-profile retirements within the hedge fund industry, most recently veteran short-seller Jim Chanos, who announced in November his plan to convert to a family office. Ray Dalio, the face of Bridgewater, retired this year.

Consolidation within the industry has made the pod shops like Millennium Management Global Investment and Citadel bigger. These multi-manager platforms have replicated trends in other parts of the asset management industry by bringing high-performing investment teams in-house, creating a one-stop shop for institutional investors who want to write big tickets to fewer managers. These platforms can also contend with growing regulatory costs and complexity, giving them a leg up on single-manager shops and new managers, both of which face increasing headwinds.

But it also means that, going forward, the industry is less likely to see a constellation of star managers taking high-profile positions on markets. These trends, coupled with an investor focus on strategies that offer high liquidity and capital efficiency, could indicate a shifting role for hedge funds in portfolios and the market.

Investor Focus on Diversification

Hedge funds performed well in 2022, which led many institutional investors to take profits out of their hedge fund positions, which were overweight at the end of last year. According to Ryan Lobdell, managing principal in and head of marketable alternatives at investment consultant Meketa, this trend has continued in 2023 and may play out into next year. That could make it hard for the hedge fund industry to grow, even if performance remains relatively high.

“Over the past 18 months or so, there’s been an improved outlook for hedge funds, and investors may want to allocate more,” he says. “But they might be overweight private markets and are kind of at an impasse until things return to something more normal or those issues are resolved. That could take time to resolve itself. That’s a trend that’s still playing out that could limit some of the growth we see in hedge funds.”

For the allocations that remain, Lobdell notes there is an increased focus on strategies that provide diversification and have looser liquidity terms. “A lot of investors use risk-mitigating strategies, things that are intended to diversify equity risk. Many of those trade derivatives, strategies like long volatility or trend following,” Lobdell says.

James Medeiros, president of Investcorp-Tages Ltd., sees the same thing. “I think investors have learned more about how hedge fund strategies typically work in portfolios,” he says. That drives interest in quant funds and systematic strategies that are more opportunistic and easier to get in and out of. “If you look at certain strategies like CTAs, for example, those strategies tend to be very episodic. They can have a very good run—it might be for six, 18 or 24 months—but then they often revert back to the mean. So investors have learned that it’s absolutely appropriate to harvest some of the profits from those strategies when they arise.”

That result can be helpful for investors who need to step down some part of their private markets allocation to remain within investment limits or meet capital calls. But Meketa’s Lobdell notes it is important for investors to maintain a long-term view of the asset class; while profit-taking can be helpful, there still needs to be a plan in place to rebalance back into hedge funds at some point in the future or investors may lose some of the benefits of diversification.

Platforms vs. Specialists

The desire for diversification is also driving how investors think about where to invest, not just which strategies to invest in. Over the last decade, pod shops have effectively marketed themselves as multi-manager platforms that offer diversification and high returns. That value proposition has been compelling enough to see assets at Millennium climb to $60 billion, as one example. But rising rates could put pressure on these platforms.

The math is pretty simple, sources say. If a platform is returning 6% to 11% per year with fees attached and the return on cash is 5% to 6% without fees, paying the kinds of fees elite managers demand is harder to swallow. Medeiros says he expects that when investors start evaluating portfolios at the end of this year, fees and hurdle rates will be front of mind.

“We’re seeing investors talking more about re-rating their portfolios looking at how managers did in ’22 and ’23,” he says. “They are looking at their strategy allocations and also whether managers are doing things like beating the cash rate and, if not, if there is some other compelling reason to keep them.”

Medeiros adds that when investors are focused on liquidity and looking for tactical opportunities, platforms may have a harder time making a compelling case.

“Many platforms have done a great job over the past five to seven years, so you have to give some credit where credit is due. But I think, equally, the aggregation of capital among the bigger managers leads to certain trends,” he explains. “The bigger get bigger: Institutions gravitate to bigger managers because there is a perception of safety, which gives [those managers] an advantage. But we are also of the view that sometimes smaller managers—specialist managers—can be better positioned to take advantage of certain opportunities. We do a variety of things from investing with external managers to running some strategies ourselves.”

Meketa’s Lobdell agrees. He says investors need to look at the profile of their hedge fund allocation in totality.

“If an investor has a lot of exposure to pod shops, it’s important to allocate to other strategies that might be complementary—or have different return drivers or even [different] underlying risk factors to them,” he says. “Investors also want to have a good understanding of liquidity profiles and what role these platforms are playing in the portfolio. A lot of large hedge funds have produced really great performance, but liquidity factors can also have an impact. If you’re going to need to get your capital out frequently, then that could be a consideration in terms of whether or not it makes sense to have those platforms in the portfolio.”

Kenneth Tropin, chairman and founder of Graham Capital Management, adds that the investors he works with often want a level of customization and capacity they can’t get from platforms. “There’s a large number of allocators that want to work with us to solve specific needs that they may have in their portfolio. That’s not something you can get from platforms, especially if you need a high level of customization,” he says. “A number of our clients come to us with very specialized requirements such as providing them with risk mitigation strategies that are designed to provide alpha with an added layer of beta hedging.” Tropin says those solutions are likely to become more popular if the current environment of high interest rates and higher volatility persists.

Blurred Lines, New Opportunities

As we move through the end of the year and into 2024, investors have more clarity on interest rates, but volatility appears likely to remain elevated. The Federal Reserve’s position of higher for longer will keep the cash rate high and is likely to create more dispersion in the credit markets, which could create new opportunities for opportunistic hedge fund managers. Equities have had a solid run this year, and new questions about the impact of a slowing economy could create dislocations in the equity market next year—the kind of environment that favors active management.

“The question going forward is: What’s going to happen in credit and credit strategies? I think the case is positive overall. The opportunity set is getting better,” says Jens Foehrenbach, CIO of Man Solutions, part of the Man Group. But he notes that the lines between credit hedge funds and private credit funds have started to blur. Several strategies may look similar, with the primary difference being the lock-up period. Hedge funds typically have shorter lock-ups than private credit funds.

Global macro strategies may also be on pace to have another big year in 2024. “We’re seeing a lot of interest in macro strategies from investors because there are so many crosscurrents in the world right now that make macro very interesting,” Graham’s Tropin says. “Monetary policy is in a state of flux globally, which creates a potentially constructive environment for global macro trading.”

Those crosscurrents are also driving an interest in rules-based equities strategies. “Given the dispersion happening within equities, there’s also a good opportunity for quant strategies,” says Man’s Foehrenbach. “We have more data available now. The use of alternative data, as well as sophisticated systematic strategies that rely less on fundamental inputs, are providing unique opportunities. Those are exciting developments.”

These technologies are likely to drive most of the innovation in hedge funds, mostly from within existing shops. The number of new hedge fund launches is steadily declining, as the cost to start new firms reaches new highs and fewer investors are willing to bet on emerging managers.

Tropin says some of this is the result of an industry that’s maturing. The barriers to entry get higher over time. “I do think we will see fewer hedge fund startups. I think the innovation will be found at mature firms,” he says. “We are working very hard to innovate new sources of alpha every day. And frankly, it’s a necessity. We always want to be as creative and innovative as possible and find new sources of potential returns in alpha that we don’t think other people have discovered.”