Hedge funds need to strike the right balance between macro pressures and the often differing needs of its clients if they are to survive, according to a new report by FIS, a specialist in financial services technology.
The report – Growth 2020: The Changing Chemistry Between Hedge Funds and Investors – canvassed responses from 258 executives from hedge funds, administrators, prime brokers, custodians, consultants and investors. It highlights a number of key findings on how investors and hedge funds view the future of the industry and what the main challenges are. The upshot to the report is that the success of today’s hedge fund manager hinges on creating a meaningful chemistry between the fund and its investors.
Top 3 challenges
AUM growth, keeping pace with regulatory change and fee pressures are the top three challenges, with the report noting that the higher costs of running a hedge fund directly impact marketing capital, thereby inhibiting managers to effectively build out their AUM. Regulatory change and growing AUM have become intrinsically linked.
Of interest is how different respondents viewed industry challenges. Whereas growing AUM was considered the biggest challenge among managers (56 per cent), three quarters of investors said it was fee pressure, with 70 per cent of administrators suggesting the biggest pain point facing the industry was keeping pace with regulatory change.
In order to best serve their investors it is incumbent upon managers to understand how their motivations differ. The report finds, for example, that whilst HNW Investors primarily choose to invest in hedge funds for return enhancement and portfolio diversification, institutional investors do so for portfolio diversification and risk reduction benefits. Another interesting finding is that whereas 44 per cent of institutions invest in hedge funds for volatility dampening, this was cited by only 11 per cent of HNW Investors.
The ability to juggle these different demands is no easy task.
As the report states: “To maintain the chemistry between investors with differing objectives, hedge funds must develop joint strategy objectives and balance the needs of their investors.”
Product/strategy disconnect
In terms of new product/strategy developments over the next two years, there again appears to be some disconnect between investors and hedge fund managers; only granted, this is only one study. Nevertheless, the report shows that strategies favoured most by investors are Equity Long/Short (67 per cent), Market Neutral (40 per cent) and Event Driven (38 per cent). In contrast, only 27 per cent, 16 per cent and 6 per cent of managers cited these same three strategies as part of their plans.
Moreover, whereas one quarter of investors expressed an interest in Bank Loan and FX strategies, only 2 per cent of managers responded in kind.
Where there does seem to be some synergy and alignment of interests is with respect to Liquid Alternatives and CTAs/Managed Futures.
The rise of the millennial investor
Changing investor demographics and investment in improved technology are regarded as two important enablers of growth in the hedge fund industry. Investors are more bullish on the impact of disruptive innovation. By contrast, market regulation, specifically AIFMD, is viewed as having a negative impact on growth by 65 per cent of hedge funds over the next two years. MIFID II and FATCA are also likely to make life harder for managers. Having to commit increased capital and resources to comply with these regulatory requirements is a major hardship, especially for small funds.
With respect to the changing demographics, over the next few years millennial investors will increasingly replace baby boomers as the new wave of investors into hedge funds. However, managers cannot rest on their laurels and assume that the dynamics of those relationships will be the same as in the past. Millennial investors are tech-savvy, interested in ESG issues and ‘green’ investing and more inclined to do their own research and invest directly with the manager.
As such, regulated transparent structures including ’40 Act funds, UCITS and ETFs are likely to be launched by managers to cater to this younger set of HNW Investors. “Hedge funds that wish to win or keep their business will need to prioritize how they communicate with this audience,” states the FIS report.
Technology investment to enhance communication
Of course, improving the way that hedge funds interact and communicate with new investors requires new technologies and enhanced operational controls. Most hedge funds seem to recognize the need for technology investment, with 57 per cent saying they are likely to increase their IT spending over the next 12 months.
This in turn will help improve transparency and allow hedge funds to more effectively build investor relations. Nearly three quarters of investors (74 per cent) expect to receive weekly reports with 33 per cent of HNW Investors requesting intra-day reports. As more millennial investors enter the market, this expectation for data and reporting ‘on demand’ will likely increase.
To attract investors and rebalance the chemistry that exists between hedge funds and different types of investors, the FIS report suggests, “hedge fund managers should look for an operating model that allows them to be transparent, flexible and innovative”.
Leverage your administrator
The report goes on to point out that one of the techniques that hedge fund managers could consider for maintaining their long-term survival is to leverage the relationships they have with their service providers, in particular their fund administrator. Fund administrators can provide logistical and operational support for hedge funds, including technology around reporting and communication.
Some 40 per cent of fund administrators surveyed said they would increase investment in technology services over the next five years. Two-thirds cited additional functionality requirements as the key driver behind their IT spend over the next two to three years.
Getting the right administrator can be critical to whether a hedge fund thrives or dwindles away and as the FIS report rightly states, the challenges hedge fund administrators face impact fund managers themselves, “making fund administrators yet another element in the changing chemistry between hedge funds and their investors”.
Platform for growth
The ability to acquire new clients rests on the ability of hedge funds to adapt to new clients’ demands. One strategy for doing this is to invest in technology to improve the client experience. According to the FIS survey results, 57 per cent of hedge funds expect to increase their IT spend in the coming year. Moreover, 43 per cent of respondents expect their greatest increase in overall investment to be in customer acquisition and market expansion.
The inference here is that managers view technology as a platform for growth.
A second strategy for growth is through efficiency. As the outsourcing model is more accepted by institutions, it is a pathway that managers might look to leverage for greater flexibility and reduce operating costs.
For example, investor reporting, which attests to a fund’s performance and credibility, is managed in-house by 91 per cent of EU-based managers and 72 per cent of all managers surveyed. Middle-office functions are managed in-house by 65 per cent and technology is managed in-house by 58 per cent.
In conclusion, the FIS report states that if hedge funds wish to expand AUM, they must differentiate themselves and innovate. For example, millennials want more participation and control over their own investment decisions and actively find their information online.
Hedge funds must also be ready to demonstrate effective risk management and robust operational controls to satisfy investors and the regulators. “By 2020,” says the report, “we expect to see more direct investment in hedge funds by HNWIs, without mediation, or indirectly through wrappers in established markets.”
