Hedge fund managers expect their returns to drop, on average, over the next 12 months and are exploring new strategies which are less reliant on beta exposure for returns, according to a report by Mercer Investment Consulting.

The Mercer report, which analysed global trends and managers but was co-written in the firm’s Sydney office, says that between 100 and 150 new managers establish hedge funds every month. About 50 per cent of their funds under management come from institutional investors. The report says: “We find that our survey participants have delivered gross returns of cash plus 7 per cent per annum – within their 5-10 per cent targeted range. However, there has been a clear downtrend in returns during the past five years. In addition, the volatility has reduced to an average of 2 per cent per annum. “Most managers expect that gross returns during the next 12 months will be in the range of cash plus 0-5 per cent, though they still believe in their cash plus 5-10 per cent target over the longer term. “In our view, the managers are still adjusting to the lower return environment hence we believe that excess returns, over cash, are unlikely to return to the levels seen in the 1990s during the next three to five years.” Despite the medium-term outlook for more subdued returns, Mercer says that the managers expect their fees to increase, partly to offset increased costs associated with compliance and risk reduction as well as capacity constraints. “We note that most participants expect an increase in fees, especially for the more well-established players with long track records,” the report says. “Increased compliance and organisational costs are an additional incentive to raise fees. In terms of available capacity, on average, 50 per cent of the underlying managers used by our participants are closed for new capacity, and lock up periods have increased as more capital is allocated to private markets.” Mercer says most managers are reducing their exposures to “homogenous” strategies where participants research a similar universe, and have increased exposure to capital structure arbitrage strategy and other fixed interest strategies. Due to the increased diversification of funds of funds, the convergence in returns and volatility and the diminishing opportunity to add value in some hedge fund strategies, research efforts in this area could become increasingly focused, Mercer says. “More time could potentially be spent looking at the more concentrated funds that are designed to achieve higher returns or are designed to achieve specific exposure such as sector funds, long/short equity or credit funds.”

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