Barclays predicts significant inflows into hedge funds despite performance concerns

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Prime Brokerage
15 Jan, 2014

Barclays Prime Services is predicting new flows into hedge funds could reach levels not seen since 2007 despite 46% of investors complaining managers had failed to meet their return expectations.

The study predicts hedge funds could see inflows of $80 billion in 2014, a 25% increase from 2013, following markedly improved performances across strategies last year. Hedge Fund Research, the Chicago-based data provider, said the average hedge fund posted gains of 8.7% last year, the best performance showing since 2009.

Of these new flows, 60% is likely to be derived from institutional investors, of which 45% will come from public and private pension funds. Forty per-cent of new flows are expected from private investors such as private banks or wealth managers. The study said 82% of investors planned to increase or maintain the number of hedge funds in their portfolios, while 91% said they would grow or maintain their portfolio allocations to hedge funds in 2014.

The best capital raising opportunities for managers continues to be in North America, where the majority of hedge fund assets originate from (58%), followed by Europe (24%), Asia (12%) and the Middle East (6%). A number of managers are refocusing their marketing efforts on North America as European institutions scale back their exposure to hedge funds. Furthermore, managers are nervous about the implications of the incoming Alternative Investment Fund Managers Directive (AIFMD) which is likely to make selling to EU allocators a far more onerous and costly process.

“North America does represent the largest asset raising opportunity for hedge funds. Additionally, the implementation of AIFMD in Europe has made it more difficult for non-European hedge funds to raise assets in Europe. However, European investors still account for the second largest global pool of investable assets with $24 trillion and, combined with a reduction in competition due to AIFMD, this may make European investors quite attractive to some hedge funds,” said Anurag Bhardwaj, head of hedge fund consulting at Barclays Prime Services in New York.

Despite the high level of new flows, a significant minority of investors have said hedge fund performance has disappointed. Fifty-one per-cent of funds of hedge funds and 56% of private investors said hedge fund performance was lacklustre. The majority of these investors blamed the substandard performance on managers taking too little risk or demonstrating poor market timing. Forty per-cent cited macro factors as being a key contributor to the questionable performance while just 4% blamed new regulations. “Others felt the hedge fund industry has grown too large relative to available opportunities,” added the study. However, 54% of institutional investors and 70% of consultants said hedge fund performance met or exceeded their return expectations

In terms of strategies, investor interest in equity and event driven managers are likely to grow, while macro may also see some inflows despite posting negative returns. The study said investor appetite for less liquid hedge fund strategies would also increase with half of all allocators expressing an interest despite these managers posting only marginally better returns than liquid hedge funds.

“Some investors today do believe that there are significant alpha generation opportunities that require an investment horizon greater than one or even two years. They also feel that these investment opportunities are relatively underexploited due to investors' desire for much greater liquidity in their hedge fund investments in recent years,” commented  Bhardwaj.

In 2013, a J.P. Morgan prime brokerage study said a rising number of credit-focused hedge funds offering hybrid fund structures akin to private equity had entered the market. The J.P. Morgan study attributed this to the growing investment opportunities available in less liquid distressed assets. Basel III and other national regulations forcing banks to deleverage and restructure their balance sheets have prompted sell-offs of non-core assets such as collateralised loan obligations (CLOs) and residential mortgage backed securities (RMBS) creating opportunities for managers pursuing distressed strategies.

Twenty-nine per-cent of allocators also told Barclays Prime Services they planned to add regulated or liquid alternatives to their portfolios in 2014, a 6% increase from 2013. A number of service providers are bullish on the future of liquid alternatives.  Citi Prime Finance itself said it expected $939 billion of the $12.8 trillion in retail assets available to flow into liquid alternatives by 2017. 

One of the key investor targets among managers running regulated alternatives is the Defined Contribution (DC) pension plan market. A report by SEI said 60% of the DC plan market’s $5.1 trillion in assets were parked in mutual funds, adding this investor class had historically been averse to alternatives. The SEI report said plan sponsors had become emboldened and were increasingly investing in real estate, inflation protected treasuries and commodities in search of greater yield.

40 Act hedge funds are not without their challenges. While the distribution benefits are hard to falter, 40’ Act hedge funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 bps and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding. These costs could also make it unsustainable for smaller hedge funds to launch regulated products.

Bhardwaj remained optimistic though about the prospects of ’40 act hedge funds. “We do not believe that the excitement is exaggerated. While the investment restrictions and compliance obligations are onerous, there are ways to make addressing these relatively painless. Additionally, the sheer size of the asset pool represented by the US retail and retirement market alone with $19 trillion in assets is probably very attractive to 40 Act hedge funds. Finally, for many hedge funds, these products offer an opportunity to diversify their investor base and their revenue profiles,” he said.

Systematic strategies and commodity trading advisors (CTAs) are likely to struggle to raise meaningful assets, the Barclays study added. CTAs and other trend following hedge funds have had a hard time performing in this tough macroeconomic terrain posting losses in the last five months of 2013. This has prompted a number of investors to curb their expose to CTAs – a mid-year study by Credit Suisse’s prime brokerage group revealed just 7% of allocators planned to increase their investments into CTAs, a downward swing of 30% from 2012.

Barclays Prime Services surveyed 220 investors with $5 trillion in Assets under Management, of which $490 billion was invested in hedge funds. 

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BarclaysAIFMDJ.P. Morgan'40 Act fundsCitiSEIMcKinsey& CoCredit Suisse

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