December 05, 2022
What is a hedge fund?
Hedge funds are investment companies that make alternative investments and perform trades from pooled investment funds. Hedge funds find their success in utilizing complex trading techniques, focusing on risk management, and leveraging short selling.
Hedge funds are unique from other investment companies in that they are not seen to be as regulated as mutual funds and exchange-traded funds (EFT). Additionally, hedge funds are considered open-ended which allows investors to pull out capital depending on the current status of the value of the assets. This is different from private equity firms (PE), in that PEs are considered closed-end funds and only invest illiquid assets over longer periods of time before any withdrawals occur.
2023 and beyond: hedge fund industry trends
The hedge fund industry has not enjoyed one of the best performances in the past decade, but recent data shows that this could change in 2023. In fact, this class has surpassed the S&P 500 last year, starting to prove its worthiness not only as a means for diversification but also for returns. The coronavirus pandemic has brought unexpected challenges for investors, and some trends created in 2020 are bound to continue in the next years. The following sections look at the top hedge fund industry trends in 2023 and beyond.
Hedge fund performance in the past has not been very rewarding, but the recent market crash showed investors why hedging is so essential. Despite a negative public perception, hedge funds managed to record impressive performance, although the allocation was reduced from approximately 40% in 2018 to only 23% in 2020. Being actively managed, hedge funds might perform better than expected in the following years. Let’s see the most prevalent hedge fund trends of the future and why they are likely to impact investment decisions.
1. Continuous growth and outperformance
Hedge fund assets are expected to balloon in 2023, fueled by the most significant growth in the past ten years. The last decade was marked by performance growth, while this year is expected to record an all-time peak due to net inflows.
In 2020, fund performance in this industry generally met investors’ expectations despite the pandemic. A continued positive performance after Q1 led to improving investor confidence; the continuous growth in the hedge funds industry is expected to come from allocating funds to strategies with higher expected returns, shifting away from low-yielding fixed-income investments.
2. The revival of long-short equity
The hedge fund industry used to be dominated by long-short equity, reaching approximately 40% of all the industry assets. Long-short equity refers to taking a long position in underpriced stocks and short stocks that investors expect to decrease. However, this strategy started to underperform in the past ten years, showing investors that other strategies, such as CTAs or other fixed income strategies, have a better performance.
One of the causes for the decreases in long-short equity was related to prominent tech names and passive S&P 500 index funds. This ballooned the large growth stocks and the index, negatively impact the relative valuation of small and large-cap stocks, value and growth stocks, and US and foreign stocks.
In other words, many investors spotted the opportunity to use fundamental research while relative valuations are still behind historical averages. This leads to the expectation of returning to wide adoption of long-short equity strategies.
3. Hedge funds and private equity
Hedge funds and private equity firms adopted similar strategies; typically, private equity firms offer a drawdown structure, while hedge funds provide evergreen structures. However, the last ten years registered a more blurred offering. In other words, hedge fund managers started to provide both evergreen and drawdown funds.
Another change brought by the blurred line between hedge funds and private equity refers to research departments. While these used to be organized according to fund structure, teams are now shifting to organization according to asset class or strategy. This convergence between the two can impact the entire hedge fund industry. For instance, private equity firms are already included in capital introduction events.
4. Growth of alternative investments
The current pandemic is not the only factor behind healthcare institutions’ emergence as a standalone investing category. This was already fueled by existing characteristics, such as an aging population and massive medical technology investments. This segment has always been one of the fastest growing and is likely to retain this position in the future.
Numerous healthcare institutions invested billions of dollars in a broad range of assets, including pension funds, foundations, and others. As the expertise in alternative investments continues to grow, the hedge fund industry will see major improvements in this category.
5. Better access to investor meetings
The pandemic has changed the way people work. The broad adoption of virtual meetings forced the hedge fund industry to adapt. In turn, this led to reduced time and expenses for investors and managers, among others. Scheduling flexibility and other benefits of virtual meetings allow investors to take advantage of this new practice, so it is likely to remain in 2023 and beyond.
Another benefit is that early-stage virtual meetings allow smaller funds to enjoy better access to investor meetings. As a result, it is expected that a substantial portion of introductory meetings and other events are carried out virtually. In contrast, later-stage meetings might still take place physically when possible.
6. Focus on ESG
Although ESG in the hedge fund industry is not news, there was little to no implementation. In the past years, many European institutions have already integrated ESG in investment diligence, and it seems that it will become the new standard.
The coronavirus pandemic has highlighted economic and social inequalities, so there is an increased focus on social justice. Public and private pension funds, sovereign funds, and endowments foundations reach about 65% of the hedge fund industry and play a crucial role in this matter.
While ESG criteria started simple, such as restrictions for tobacco or alcohol industries, they are ow becoming more complex. Investors can filter companies according to third-party ratings, and those companies with low ESG scores can be excluded from the portfolio.
7. Workforce diversity
A current method is to focus on different sub-categories of ESG, such as adding assets related to renewable energy to address climate change. While this practice is quite common for private equity, it is expected that it will find its way into the hedge fund industry, too. Even more, it is expected that the ESG criteria will also apply to the investment manager; for instance, institutional investors are screened according to workforce diversity, so hedge fund managers are expected to adopt diversity policies to ensure future success.
8. Growing interest for North American investors
It is expected that a significant and permanent change in 2023 and beyond is related to Brexit. In the European Union, free trading between the member countries puts non-EU countries at a major disadvantage because of the struggle to comply with EU regulations. UK hedge funds are the second largest market worldwide, so some argue that the focus will shift to North American investors rather than European ones after the finalization of Brexit.
9. Decreasing fees and outsourcing
The hedge fund industry is under current transformation due to the increasing costs of having a hedge fund firm while fees decrease. As a result, more and more small- and medium-sized businesses will seek to outsource many activities to reduce expenses, including technology, accounting, compliance, marketing, and other research- and investment-related activities.
Outsourcing these aspects of hedge fund businesses will offer lower fees, higher efficiency, and greater expertise. Large hedge fund businesses with their own infrastructures may seek revenue diversification strategies, such as acquiring competing firms.
10. The growing importance of private credit strategies in markets
Although institutional investors have been increasing their focus on private credit strategy markets, this is expected to be maintained throughout 2023 and beyond. Last year changed the way business works and even challenged many firms’ viability, even though governments offered extensive liquidity support. Many firms could not access these funds, so private credit managers had to fill in this need.
For investors, private credit helped to achieve a new type of income, hedge, and even diversification due to the increasing volatility of their investments and lower fixed-income yields as a result of the pandemic.
11. Technological developments
The digitalization trend has reached new peaks due to the coronavirus pandemic. Many businesses realized the necessity of having a robust infrastructure, and many firms in this industry turned their attention to ICT abilities. Many have already started to use public web data as one of the main components of their decision-making process, and there are numerous opportunities for technological developments to impact the hedge fund industry trends in 2023 and beyond.
Apart from upgrading the investment process, digital assets, including cryptocurrency, continue to grow. For instance, more and more hedge funds stand out from the crowd due to their attention to blockchain and DLT (distributed ledger technology) space. This alternative asset class is still in its infancy, but it is expected to grow and become more and more important in the next years.
12. Machine learning and artificial intelligence
The investment world is rapidly expanding to include non-standard methods in an attempt to beat the market. For instance, more and more hedge funds now include AI (artificial intelligence) and machine learning methods in their processes.
These developments help hedge fund managers to increase the accuracy of their predictions by using public web data. For example, investment decisions can be made using non-traditional information, such as geolocations, credit card transactions, and more. It was proved that these hedge funds had better performance in the long run compared to others.
13. Adoption of defensive hedge fund strategies
The hedge fund industry trends seem to focus more extensively on defensive strategies, which means that it becomes more stable. Some of the most favorable options include hedge funds that adopt quant investing, but also multi-strategy ones. Generalist equity has also registered some increase, but not as high as market neutral, sector-specific, and others.
14. Increased challenges in raising funds
There is a rising gap between small hedge fund firms and larger businesses. The latter category has been able to raise money, while less established businesses are not as successful in fundraising. In other words, mid-sized companies and those without a strong track record have issues with attracting investors. Despite this, the general sentiment regarding fund allocation to hedge funds is optimistic for 2023.
15. The emergence of cryptocurrency hedge funds
As technological developments affect the world of investment, most of the current cryptocurrency hedge funds were founded in 2018 and 2019. These are not only funds that have exclusive cryptocurrency portfolios but may also combine other financial assets using different hedge fund strategies. Many of these cryptocurrency hedge funds are located in the United States and the United Kingdom, but it is expected to become widespread in the following years.
16. Active management in 2023 and beyond
According to a global survey, allocations to hedge funds dropped from 40% in 2018 to only 23% in 2020. This decline was correlated with increases in private equity, credit, and real estate. Despite this lack of investor confidence in hedge funds’ ability to perform, they registered impressive results during the 2020 coronavirus pandemic. In fact, many specialists argue that hedge funds will continue to rise in the next years because hedge fund strategies using active management are known to perform well during volatile, uncertain times.
17. Lower barriers to entry and fewer restrictions
Traditionally, hedge funds have always required six figures initial investments, which means that not everyone has access to them. However, this restrictive environment is bound to change in the next years. More specifically, retail-oriented and publicly traded funds already have a much smaller minimum, so there might be looser restrictions when it comes to who can invest in hedge funds, allowing for a broader expansion.
As the coronavirus pandemic changes the way people work, many hedge fund managers found themselves investing more time in technology and remote work. Most voices claim that the focus on digitalization is here to remain for the following years. With a slowly changing regulatory environment, the industry may keep expanding in 2023 and beyond.
The history of the hedge fund
According to Martin Zewieg, the history of hedge funds is said to have unofficially begun in the 1920s, during the arrival of the Bull Market in the United States. However, it wasn’t until 1949 when Alfred W. Jones coined the term “hedge” in reference to studied market behaviors. Sociologists and financial analysts at the time noticed that investors and firms utilized a strategy of managing funds and investments in accordance with monitoring risk within the financial market.
Over time, hedge funds became more popular over time, specifically in the 60s and 70s as many hedge funds focused on the short/long term equity model, which involves purchasing equity that is expected to increase in value and selling assets that are expected to decline. After a number of short recessions and stock market crashes throughout the years, hedge funds slowly lost popularity, due to their inherent high-risk strategy.
In the 1990s hedge funds became a topic of discussion, as more and more hedge funds originated during the stock market rise of 1990, which was a direct result of the dot-com bubble. Relatedly, as technology improves, AI-based tools arise, and data-driven investing continues to show proven results, the hedge fund industry continues to grow (into the trillions). Today, according to Barclays’ investor survey, it is predicted that there will be approximately $450 billion (USD) in gross allocations across the industry in 2023.
Frequently asked questions
How big is the hedge fund industry?
According to the Office of Financial Research, in 2020 the hedge fund industry market size was approximately 8 trillion (USD), and was valued at around 5 trillion (USD) around 2016, showing significant growth in industry size and market performance over the past few years.
What is a hedge fund in simple terms?
Hedge funds are investment companies that make alternative investments and perform trades from pooled investment funds.
Why do they call it hedge funds?
Hedge funds get their name from the metaphorical meaning of the word “hedge” which in many cases is used to describe something that puts a barrier or limit between an entity and a risk. While today hedge funds aren’t as risky due to improved investment strategies, the term hedge fund was coined to indicate a firm that is involved with high-risk investments.
What's the biggest hedge fund?
According to Investopedia, the biggest hedge fund in the world is Bridgewater Associates. They are reported to be currently managing over 130 billion at the end of 2020.
Can anyone start a hedge fund?
Yes, technically anyone can start a hedge fund. However, there are multiple steps that must be taken to set up a hedge fund correctly such as forming an LLC or corporation, raising capital, maintaining and establishing financial compliance, and more.
How do hedge funds pay investors?
Hedge funds pay investors with the profits they receive from their investments. Hedge funds make money though performance fees and management fees.
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