James Williams, Hedgeweek

Technology can act as a growth enabler to help hedge funds cope with increased margin pressures

Punctuated equilibrium, a term used in evolutionary biology to describe long periods of little or no evolutionary change (stasis) interrupted by short periods of significant changes, is also applicable to the wealth management industry, according to a new white paper by SEI Investment Manager Services…

The company argues that the wealth management industry is currently experiencing one of these punctuated events, experiencing significant evolutionary change. In the paper – Evolution in Asset Management – SEI identifies five trends, being released in individual chapters that are driving this change: fierce competition, vulnerable economics, emboldened investors, complex regulation and transformational technology. And hints at how investment managers might best adapt to remain competitive and, in evolutionary terms, not only avoid extinction but thrive in the future. 

In the first of a series of articles, we will explore the implications of vulnerable economics and what tactics investment managers could consider to not only bolster their revenues but create better, more scalable businesses.

As SEI points out in its paper, overall asset growth in the funds industry has been strong, rising 54 per cent between 2012 an 2017. At the same time, however, revenues grew at a slower rate of 38.5 per cent as margin pressures have begun to bite. 

For hedge fund managers, this is potentially troubling news as long-only investors continue to put downward pressure on the established ‘2 and 20’ fee structure. Since the financial crisis, equity markets have rallied almost without hindrance albeit with some day-to-day volatility, causing investors to pile in to low cost long-only passive fund products (index trackers, ETFs etc). And while hedge fund assets have remained steady and topped USD3 trillion, investor reticence over fund performance and managers’ inability to deliver value consistently, have caused managers to adjust and better align their fee structures. 

As Ross Ellis, Vice President and Managing Director of the Knowledge Partnership in the Investment Manager Services division at SEI, states, this downward pressure is happening at a time when greater regulatory compliance obligations are causing expenses to rise. 

“The more investors are interested in alternatives and the more sophisticated they’ve become, the more they insist on only paying for alpha and not market beta,” asserts Ellis. “Investors can get extremely low cost market performance in tracker funds and are only willing to pay for outperformance in alternative fund strategies.” 

On the expense side, it is getting harder for managers to contain the regulatory and compliance costs which eat in to their management fees. As the deal stakes keep rising and as investors become less willing to pay the old 2/20 fee structures, managers face a choice: either remain in stasis and hope they can survive, or use leading edge technology for cybersecurity protection, data management, compliance etc., to improve their operational model.

“A lot of investors have come from the long-only world where they are used to having total transparency and daily reported fund products,” says Ellis. “They are bringing those expectations to hedge funds and are asking for more information that managers previously did not provide. Not only do you have regulatory demands – MiFID II, AIFMD for instance – you also have rising investor expectations; this is requiring managers to spend more on their technology infrastructure, to make sure they are able to accommodate investors’ requests.”

Hedge funds have had to adjust to lower management fees in the 1 to 1.5 per cent range. For large multi-billion dollar managers, this is less of a problem but for the vast majority of small to mid-sized managers, it is causing a radical change in how the firms need to be managed. Running a hedge fund is no walk in the park. Portfolio construction and management, research spend, maintaining a robust IT infrastructure, putting proper cybersecurity and compliance programmes in place, hiring new talent: these are not functions that can be easily performed or paid for under a shrinking revenue stream.

Yet, perhaps because hedge funds have not overwhelmed from a performance perspective in recent years, large institutions are exerting their influence to drive better alignment of interests. 

SEI’s white paper notes that the Teacher Retirement System of Texas has pioneered a “1 or 30” fee structure, offering managers the choice of 100 basis points of fees in return for no performance fee charges, or getting paid solely through outperformance. 

“Are you going to eat your own cooking and receive nothing if you don’t hit your hurdle rate, or do you just want to live off 100 basis points on what might potentially be several hundred million dollars of investment?” questions Ellis. “Managers could opt for the 30 per cent performance fee if they truly have faith in their strategy and have enough resources to stay in business but many cannot live off 1 per cent management fee, let alone zero management fee.”

PwC Global AWM Research Centre analysis cited by SEI’s white paper forecasts that global management fees in alternative fund strategies (including private equity, real estate and infrastructure strategies) could fall a further 13 to 15 per cent by 2025. Specifically, hedge fund management fees are forecast to decline from 1.36 per cent to 1.16 per cent.

This begs the question: what can fund managers do to survive?    

The good news is that technology improvements and a growing array of sophisticated service providers are giving managers more choices to manage their operating expenses and react to tighter margin pressures. 

One only has to look at the range of AI-based tools being developed to automate tasks. 

Ellis’s point, however, is that fund managers need to be thinking about this now. If they wait too long and fees fall further, he says, their expenses will stay the same (or even rise further) and could force some to close down. 

“Hedge fund managers should think ahead and see how to use technology and industry partners to better scale their businesses,” he says. 

As the SEI white paper advises: “Operationally, there must be a focus on cost containment, efficiency and scalability. Counterintuitive as it may sound, this could mean hiring more talent.”

Robo advisors are already very popular with a certain type of investor – particularly younger retail investors - because they are cost-efficient and easy to use. These platforms are great at producing and presenting lots of data but it is a one-way conversation. 

Many larger, sophisticated investors looking at alternative investment funds want to discuss why managers made certain investment decisions and how those decisions, and their resultant outcomes, may affect other investments in their portfolios. They want a meaningful dialogue. 

To evolve, therefore, active managers could learn lessons from the long-only and robo world of transparency and regular reporting and look for ways for technology to do more of the operational heavy lifting, giving them breathing room to build their investor relations teams and provide a more in-depth, and valued, investor experience. 

“This might involve hiring more client service/investor relations people to explain how the fund fits into an investor’s overall portfolio and really listen to the client. This could help develop a meaningful dialogue, not a one-way diatribe,” suggests Ellis. He adds: 

“We think client service could well be the next frontier for differentiation and that will mean hiring more high quality people with different skills. If technology can do a lot of the rote work, it can free people up to do higher value activities that investors are going to be more willing to pay for.” 

In conclusion, using new technology tools in hedge fund operations has the potential to act as an enabler of growth and insulate managers from the risks of lower margins and falling revenues. 

This could be to develop new fund products, new distribution channels or launch into new markets. 

Hedge funds will increasingly need to be freed up to have the time to think more creatively and develop new investor solutions; but this is predicated on having the operational backbone in place to make it happen. 

As Ellis concludes: “The last thing you want is to come up with a great idea only to find out your operational infrastructure isn’t flexible enough to support it. Operations must be an enabler of growth, not a hindrance.” 

To sign up to read the first chapter of SEI’s white paper, simply click here.
 

Contact SEI

To learn more about how we can help you, please contact us at our main investment operational centres:

London

SEI Investment Manager Services, 1st Floor, Alphabeta, 14-18 Finsbury Square, London EC2A 1BR, United Kingdom
Tel: 44 (0)20 3810 7570

Dublin

SEI Investments – Global Fund Services Limited / SEI Investments – Depositary & Custodial Services (Ireland) Limited, Styne House, Upper Hatch Street, Dublin 2, Ireland  
Tel: 353 1 638 2400

US

SEI Investment Manager Services, One Freedom Valley Drive, Oaks, PA 19456 USA   Tel: 610 676 1270
777 Third Ave, 26th Floor, New York, NY 10017 USA   Tel: 212 336 5300
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