Jan 5 2015 | 8:11am ET

By Don Steinbrugge, CFA

Managing Partner, Agecroft Partners

Each year, Agecroft Partners predicts the top hedge fund industry trends through their contact with more than 2,000 institutional investors and hundreds of hedge fund organizations. Because the hedge fund industry is very dynamic and constantly changing, it is important for firms to anticipate what changes are likely to occur. Those who effectively evolve with the industry will succeed, while stagnant firms will be left behind. Below are Agecroft’s predictions for the biggest trends in the hedge fund industry 2015.

1. Greater Alpha Due to Decreased Correlations & Higher Volatility

Since 2009, most hedge fund returns have been driven by market beta due to rising equity and fixed income valuations. This was enhanced by high correlations and lower volatility within the capital markets. Since the second quarter of 2014, there has been a decline in correlations in the capital markets which has been accompanied by periods of increased volatility during the fourth quarter.  We expect this to continue as correlation and volatility levels move closer to historical averages. Larger price movements make it easier for skilled hedge fund managers to add value through security selection when  security prices reach price targets more quickly, thus, enabling capital to be reinvested in other opportunities.

2. Greater Demand For Hedge Fund Strategies That Benefit From Decreased Correlations and Increased Volatility

These strategies include market neutral equity, arbitrage strategies, global macro, CTAs, long/short equity and fixed income trading oriented strategies. Not only will these strategies be in demand because of their increasing ability to generate alpha, but also as a hedge to all time high equity and fixed income prices.

3. Smaller Managers Will Continue to Outperform

One of the biggest issues within the hedge fund industry has been the high concentration of flows to the largest managers with the strongest brands. This has caused many of these managers’ assets to swell well past the optimal asset level to maximize returns for their investors. As they become larger, it is increasingly difficult to add value through security selection. Large managers also have an incentive to reduce the risk in their portfolio in order to maintain assets and thereby increase the probability of continuing to collect large management fees from their client base. Finally, it becomes more difficult to stay motivated for some of the largest managers once their personal wealth reaches the stratosphere.

4. More Hedge Funds Shutting Down

Hedge funds will shut down at an increased pace driven by 4 factors:

1) Agecroft estimates that the current number of hedge funds is near an all-time high of fifteen thousand. Given a consistent rate for hedge funds ceasing operations, hedge fund closures should also be at an all-time high.

2) This increase in hedge fund managers has reduced the average quality of  hedge funds in the industry. Many of the lower quality managers will experience a higher rate of closing down, which is good for the industry.

3) Increased volatility in the capital markets increases the divergence in overall return between good and bad managers. This in turn increases the turnover of managers, as bad managers get fired and money is reallocated to those who outperform.

4) The competitive landscape for small and mid-size managers is becoming increasingly difficult. They are being squeezed from both the expense and revenue side of their businesses. In addition, having a superior quality product alone is not enough to generate inflows of capital. Hedge fund flows are being driven more and more by brand and distribution, which these hedge funds lack. As a result we expect the closure rate to rise for small and mid-sized hedge funds.

5. Hedge Fund Industry Assets to Reach All Time High in 2015

Despite all the negative stories recently about the industry including an increased level of fund closures, CalPERS pulling out of hedge funds and hedge funds underperforming the S&P 500, total hedge fund industry assets will reach a new all-time high in 2015. This will be fueled by a combination of investors moving assets out of long only fixed income to enhance forward looking return assumptions and other investors shifting some assets out of the equities to hedge against a potential market selloff. We expect hedge fund industry assets to rise by $210 billion, or 7% which was derived from a forecast of a 2% increase due to net asset flows and a 5% increase from performance.