Resilience and Resurgence of Active Management Funds, Flows, and the Future

Jefferies Capital Intelligence 2020

Active Managers have been a staple in Investment Management, with hedge funds hitting their critical mass in the late 90’s through the 2000’s. Then, a rise in Passive Management, and perceived outperformance of this cheaper alternative, impacted investor demand for active managers during the recent bull market. A volatile year has now signaled the end of an otherwise quiet decade, and Jefferies Capital Intelligence team is asking the question we’re all thinking: is active management roaring back to life?

Signs of Industry Health: Performance Asset Inflows New Launches A Product That Can Perform Over Cycles Hedge funds have protected capital and outperformed passive funds and market indices in 2020. While there is dispersion among various strategies, taking a bird’s-eye view of industry returns, hedge funds by-and-large executed on what they are meant to do… HEDGE. In addition to dampening volatility, many funds generated enhanced alpha for their investors. Looking at April-August 2020, the HFRI Fund Weighted Composite Index surged over 15.1%1, which marks the strongest five-month gain since the period ending February 2000. In the wake of a precipitous March drawdown, these returns came when investors needed them the most.

Monthly HF Performance vs the Market Cumulative HF Performance vs. the Market 01/01/20 – 08/31/20 01/01/20 – 08/31/20

iShares Dow Jones U.S. ETF (IYY) - Monthly Returns iShares Dow Jones U.S. ETF (IYY) - Cumulative Returns SPDR S&P 500 ETF Trust (SPY) - Monthly Returns SPDR S&P 500 ETF Trust (SPY) - Cumulative Returns JEF HF Manager Data - Monthly Returns JEF HF Manager Data - Cumulative Returns HFRI Weighted Composite Index - Monthly Returns HFRI Weighted Composite Index - Cumulative Returns 15% 20% 10% 10% 5% 0% 0% -5% -10% -10% -20% -15% -20% -30% Jan-20 Mar-20 May-20 Jul-20 Jan-20 Mar-20 May-20 Jul-20 Source: Factset, HFR, Jefferies Source: Factset, HFR, Jefferies During periods of acute stress, the longer the drawdown, the more substantial outperformance tends to be for active managers – regardless of the downturn’s cause. 2020’s record-setting market recovery reduced the hedge fund industry’s outperformance into year-end. But after a decade-long focus on passive, active managers were still able to remind investors of their value proposition. Who Weathers the Storm? Cumulative HF Performance vs. S&P 500 01/01/00 – 03/31/20

SPDR S&P 500 ETF Trust - Cumulative Return HFRI Fund Weighted Composite Index - Cumulative Return

150.0% 100.0% 50.0% 0.0% (50.0%) (100.0%) Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18 Jan-20 Source: Factset, HFR Resilience and Resurgence of Active Management – Funds, Flows and the Future 2020

Sustained Inflows Across the Board

Despite exhaustive headlines around fears of offsite/virtual ODD potentially halting allocations this year… hedge funds have seen the opposite. Net inflows of $12 billion to the hedge fund industry in Q3 2020 were the first net positive flows witnessed in ten quarters. These inflows (reversing a two-year trend of constant outflows), were observed across asset classes and fund strategies. This is a further sign of industry-wide growth in 2020 as active management reasserts itself as a critical component for portfolios. Reversing the Trend: Largest Net Inflows in Five Years Hedge Fund Industry Net Asset Flows ($mm) “Investors are gaining Q1 2015 - Q3 2020 market share in this $60,000 environment, have money to put to work, $40,000 and NEED to” -HF Manager, COO $20,000

$0 Industry assets have -$20,000 now surpassed all-time highs, reaching over -$40,000 $3.3 Trillion, attributed to net new allocations -$60,000 and organic growth through performance. -$80,000 2015 2016 2017 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Source: HFR 2018 2018 2018 2018 2019 2019 2019 2019 2020 2020 2020 Who’s Receiving Remote Allocations?

The bulk of net inflows from Q1 2020 stemmed from allocators writing new tickets for managers they had previously invested in, along with investors topping up and adding when possible to existing allocations. Additionally, many larger managers which had previously closed to outside capital, reopened to take advantage of market opportunities and resolve liquidity crunches, among other reasons. In an unfamiliar virtual environment, allocators noted a tendency to invest with groups where existing relationships had been previously established through onsite ODD and in-person meetings. Investors began to realize, virtual Source: HFR diligence is here to stay, and may be a change for the better…

“I didn’t know HOW I could underwrite a manager if I had never met them… yet in the past 6 months we have unwritten a handful of new managers” -Outsourced CIO, Head of ODD

LPs became more comfortable with the remote ODD and VC meeting processes, and began to actively meet and invest with new manager relationships, which may have contributed to the upswing in allocations to hedge funds in Q3. The only strategy which saw net outflows in Q3 2020 was Event Driven, but even here it was under $200 million. Resilience and Resurgence of Active Management – Funds, Flows and the Future 2020

Nevertheless, New Launches Persist

One of the most relevant barometers of an industry's strength is the willingness of new entrants to launch… and that’s exactly what we’ve been seeing from emerging hedge fund managers in 2020. New launches appear to be more resilient than expected, given what one might have expected in a harrowing year to say the least. Emerging managers’ appetite to come to market and take advantage of alpha-generating opportunities has been unphased by challenging asset-raising conditions and increased volatility.

Launching During a Global Pandemic Annual Hedge Fund Launches and Closures 2008 - Present Upon receiving hedge fund launch industry data in Q1 2020, there was slight cause for concern… net closures in Q1 were 2,000 on par with the unsettling 2008 numbers. News articles and business leaders forecasted that it was realistic to expect 1,500 rising net closures through the end of this year.

However… in Q2 2020, the market turned a corner. 1,000

Liquidations Declined. 500 • Quarterly liquidations nearly cut in half… decreasing 41% between Q1 and Q2 2020 from 304 to 178 total 0 hedge fund liquidations.

Resilient New Launches Came to Market Anyways. (500)

• Q1 2020 reported a near-record low number of hedge (1,000) fund launches, however, this metric rebounded considerably in Q2. • New launches in Q2 totaled 129, more than doubling (+53%) Q1’s numbers. Source: HFR Launches Liquidations Net New

Liquidations as a % of Total Hedge Funds It’s Both Never and Always a 2008 & 2009 vs. 2019 & 2020 (through Q2) Good Time to Launch a Fund Launching a hedge fund is a challenging endeavor when times 482 are normal… let alone when the world is so turbulent. Looking 2020 YTD 8,019 at the Global Financial Crisis (GFC) as the most recent downturn we can use to compare, analyses between 2008- 2009 and 2019-2020 are being leveraged to gauge how the industry is faring amidst recent volatility. 738 2019 8,163 There has been a lower amount of liquidations this year, as a percentage of total number of existing funds, suggesting that the hedge fund industry is more stable than during the GFC. 1,023 2009 GFC 6,883 Average liquidations (1,247) as a percent of 18% total number of hedge funds (6,864) 1,471 between 2008 and 2009. 2008 6,845 COVID-19 Average liquidations (610) as a percent of 0 2,000 4,000 6,000 8,000 10,000 8% total number of hedge funds (8,091) Liquidations Total Number of Hedge Funds between 2019 and 2020 YTD (through Q2).

Source: HFR Resilience and Resurgence of Active Management – Funds, Flows and the Future 2020

The Long & Short of It: Why Invest In Hedge Funds Now

While Active Management may have justified its place in the investment management ecosystem in 2020, their work is far from over. Numerous catalysts lie ahead for hedge fund managers to navigate and capitalize on in 2021 and beyond. As year-end prompts portfolio reassessment, investors might think about the opportunities to take advantage of favorable terms and fees, alpha- generation from macro theme positioning and sector specializations; entrusting their capital with skilled hedge fund professionals.

Seeds Planted Prior to 2020 Trending operational shifts, which were in effect before the global pandemic, have been accelerated by the events of this year. These changes in how active management operates have caused Hedge Funds to grow more favorable in investors eyes. Alignment of Interests – Hedge fund terms and fees have never been more favorable, especially in the emerging manager space. JEF 2018-2019 New Launches Main Share Class Lock-ups

• From Q1 to Q2 2020, average industry-wide Management and Incentive fees both 60% 51% declined to 1.37%, and 16.37%, respectively. This represents the lowest level for 50% hedge fund fees since HFR first began publishing these estimates. 40% 27% Over the past 5 years, Jefferies Capital Intelligence Team observed average Founders 30% • 22% Share Class fees shifted from 1.5% / 17% to 1.2% / 15.4% 20%

10% • The Soft Lock-Up Model: Utilized by over half of Jefferies 2018-2019 new launch managers. 94% of these soft lock-ups were for a 1-year duration with early 0% redemption fees ranging from 2% to 5% (3.78% average). Soft-Lock Hard-Lock No Lock-up Source: Jefferies Data Increased Transparency – Managers are more willing and able to peel back the curtain and communicate their investment processes, operations, and thoughts with investors. • Transparent ODD: Managers that historically always said • Rise of SMAs: Since 2017, 39% of JEF new launches entered no, are saying “maybe” on sharing documents and best into a “strategic relationship” with an investor(s). practices, and newer managers are exceedingly transparent. Strategic Capital Trends “I NEVER thought a manager would share their SEC JEF 2017-2020 New Launches deficiency letter, and they shared it on their SCREEN” In an SMA, largely 5% Seed/Economics • More Frequent, Informal Communication: Instead of a few popular due to their formal interactions per year, ODD teams are engaging with transparency, LPs see 33% Anchor managers on a more frequent basis with one-off questions, all portfolio positions, 33% sharing insights, and checking in for clarification, to see how while the manager SMA has full authority to managers are doing. 29% First Loss trade for the account. Source: Jefferies Data Customization: Funds Are Not All Things to All Investors Hedge funds are staying focused on their current and prospective fiduciaries, and are keenly aware that their strategies may not be a fit for all investors. Jefferies Capital Intelligence team has observed a increasing trend of customized products for LPs, dependent on return profiles, risk appetite, and thematic interest. Sector-specialist funds, mainly in Healthcare and TMT, which are uncorrelated to the broader markets, continue to be in high demand from allocators. Additionally, Financials-focused managers are emerging as we see a robust pipeline of new launches dedicated to the opportunities in this industry. Investor Demand for Healthcare & TMT Specialists Financials-Focused New Launches Q1 2017 - Present 2017 - Present Over half of the 70 financials start- 2017 2021 60 ups since 2017 25% 50 31% 40 launched this 30 year, or plan to 2018 20 launch in 2021 10 6% 0 2019 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2020 17 17 17 17 18 18 18 18 19 19 19 19 20 20 20 20 25% 13% Source: Jefferies Data Source: Jefferies Data TMT Healthcare Footnotes 1 HFRI Indices August 2020 performance notes. 2020. Available At: https://www.hedgefundresearch.com/hfri-indices-august- 2020-performance-notes

Disclaimer

THIS MESSAGE CONTAINS INSUFFICIENT INFORMATION TO MAKE AN INVESTMENT DECISION.

This is not a product of Jefferies' Research Department, and it should not be regarded as research or a research report. This material is a product of Jefferies Equity Sales and Trading department. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of the individual author and may differ from the views and opinions expressed by the Firm's Research Department or other departments or divisions of the Firm and its affiliates. Jefferies may trade or make markets for its own account on a principal basis in the securities referenced in this communication. Jefferies may engage in securities transactions that are inconsistent with this communication and may have long or short positions in such securities.

The information and any opinions contained herein are as of the date of this material and the Firm does not undertake any obligation to update them. All market prices, data and other information are not warranted as to the completeness or accuracy and are subject to change without notice. In preparing this material, the Firm has relied on information provided by third parties and has not independently verified such information. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. The Firm is not a registered investment adviser and is not providing investment advice through this material. This material does not take into account individual client circumstances, objectives, or needs and is not intended as a recommendation to particular clients. Securities, financial instruments, products or strategies mentioned in this material may not be suitable for all investors. Jefferies does not provide tax advice. As such, any information contained in Equity Sales and Trading department communications relating to tax matters were neither written nor intended by Jefferies to be used for tax reporting purposes. Recipients should seek tax advice based on their particular circumstances from an independent tax advisor. In reaching a determination as to the appropriateness of any proposed transaction or strategy, clients should undertake a thorough independent review of the legal, regulatory, credit, accounting and economic consequences of such transaction in relation to their particular circumstances and make their own independent decisions.