Agecroft Partners Predicts Top Hedge Fund Industry Trends for 2023

Don Steinbrugge, the founder and CEO of Agecroft Partners LLC, this week released his list of top expected trends for the hedge fund industry in 2023, touching on the opportunity afforded the sector by heightened market volatility in 2022 (expected to persist into 2023), the effects that higher interest rates have on the vertical and how small managers will outperform in the space.

This year’s predictions mark the 13th annual set released by Agecroft Partners, and Steinbrugge said he anticipates an increase in expected returns for a diversified hedge fund portfolio, citing the effects of a higher risk-free rate.

“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,” Steinbrugge wrote. The higher rates “will have a dramatic impact on the relative demand for some hedge fund strategies,” penned Steinbrugge. Specifically, Steinbrugged indicated that funds with high sharpe ratios, low volatility strategies, whose annualized returns fall below the required return minimum hurdle (the expectations for a diversified hedge fund portfolio being in the mid-single digits, 7-9%), will be the most effected by an impasse in demand.

Furthermore, Steinbrugge cited higher interest rates as a reason he expects an increase in demand for strategies that hold excess collateral.

“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,” Steinbrugge wrote. “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 and short-term fixed income positions include commodity trading advisers, reinsurance hedge funds and market neutral long-short equity funds.

Continuing to discuss the effects of interest rates on the hedge fund industry, Steinbrugge wrote, “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.”

Many institutional investors maximize expected risk-adjusted returns using a multi-asset portfolio, and the calculations to determine optimal asset allocations require assumptions for return and volatility for each asset class, as well as the correlations across asset classes with ample assumptions. Steinbrugge wrote he believes the industry will be reviewing its risk modeling due to higher rates and the circumstance of both volatility and correlations across asset classes increasing dramatically, resulting in larger than expected portfolio losses, as when markets sold off last year.

As a result, he expects there to be greater alpha this year due to higher volatility. Greater volatility, a continuation of last year’s trend, “makes it easier for managers to outperform passive benchmarks, as larger price movements help skilled hedge fund managers add value through security selection; [which] should particularly benefit long/short equity managers, especially those that focus on small and mid-capitalization stocks.”

In 2023, Steinbrugge indicated he expects the macro-economic environment will lead to a decline in the number of hedge fund organizations, a continued high concentration of net flows going to a small percentage of managers with the strongest brands, and that smaller managers will outperform large managers.

Steinbrugge points out that one of the biggest issues plaguing the hedge fund industry is the high concentration of net flows going to the largest managers with the strongest brands. As a result, Steinbrugge writes that the concentration of net flows to the few large well-known managers, “has caused many of these managers’ assets to inflate well past the optimal asset level at which they can maximize returns for their investors, [making] it increasingly difficult to add value through security selection.” Although large managers outperformed their smaller peers in 2022, Steinbrugge noted this outperformance as an aberration from the long-term trends within the industry.

Steinbrugge wrote, “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 midsize 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.”

Furthermore, Steinbrugge shared that hedge funds face steep competition, in the hedge fund marketplace. As a result, “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 midsize 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,” Steinbrugge wrote.

Steinbrugge’s trends for 2022 included a resumption to in-person meetings with investors and conferences, the continuation of virtual work to save time, money and effort within the industry, the line of hedge funds and private equity continuing to be blurred, lower private equity returns in 2022 following a decade of out-performance, and that hedge fund managers would prioritize international equities, and small and mid-cap companies in lieu of the mega cap domestic names in the equity space. While incorrectly predicting, that 2022 would hold in store a record for hedge fund flows.