Hedge funds must keep up with investor demands

Hedge fund managers are feeling the pressure as investor demands continue to evolve - those who adapt quickly will be the most successful in achieving growth.

This blunt assessment is drawn from the Ernst & Young (EY) 2016 Global Hedge Fund and Investor Survey, which looks at whether adapting to today's evolving demands will help industry players to stand out tomorrow.

The 10th annual survey found growth has slowed for various reasons, including the abundance of low-fee passive investment options, the lacklustre performance of hedge funds and cost concerns.

This year, for the first time since the 2008 financial crisis, the proportion of North American investors who said they were reducing allocations to hedge funds exceeded the proportion of those planning an increase. A key factor is that investors now have more options than ever.

They are allocating funds to those managers with a unique offering that can satisfy a specific need. Hedge fund managers must pay heed to what their investors want to keep pace, or risk being left behind.

  • 23%

    Investors in Europe and the Asia-Pacific who expect to increase their allocations to hedge funds in the coming years.

    56%

    Managers who say asset growth is their first priority, even though they are facing an unprecedented change in investor appetites that could affect growth strategies.

    20%

    Investors who are currently satisfied with the expense ratios of their funds.

Mr Michael Serota, EY's global leader for hedge fund services, said growth is the industry's top priority, but managers are changing the strategies employed to achieve it.

"While the largest managers are pursuing several growth strategies, the smaller ones are more narrowly focused, seeking to expand investor bases within their home markets. In today's challenging environment, it is imperative for managers of all sizes to identify the clients' needs and align product offerings," he said.

The picture is rosier outside the United States. A larger proportion of investors in Europe and the Asia-Pacific (23 per cent) said they expected to increase their allocations to hedge funds in the coming years.

Mr Brian Thung, EY's Asean wealth and asset management leader, said the reason is that pensions and endowments in the Asia-Pacific tended previously to allocate a smaller proportion of their portfo- lios to hedge funds, and remain bullish in embracing this asset class as their allocations catch up to those by North America-based investors.

Hedge fund managers are focusing on asset growth to counter reduced inflows. More than half (56 per cent) said asset growth was their first priority, but an unprecedented change in investor appetites could affect growth strategies.

Almost half of investors (48 per cent) expected their hedge fund investments to move from traditional funds to other options in the next three to five years; 42 per cent expected to move from co-mingled hedge funds to customised vehicles and segregated accounts.

Still, some managers are falling behind on demand for products. Investors have a broad appetite for real assets (63 per cent invested), private equity (59 per cent), long only funds (56 per cent) and best ideas funds (51 per cent), but only a small proportion of hedge funds currently offer such products or plan to.

The largest managers have the momentum to attract capital as one in three offers private equity, real asset strategies and best ideas vehicles, whereas smaller managers show single-digit percentages.

Mid-sized and smaller managers do expect to catch up: 33 per cent of mid-sized managers and 48 per cent of small hedge managers said they saw their firms offering some non-traditional hedge fund products in three to five years.

Mr Thung said: "We are seeing assets flowing to managers that offer a wide array of non-traditional hedge fund products. Managers that do not respond to changing preferences must ensure they offer something unique to potential investors."

As fee pressures increase, hedge fund managers need to innovate and optimise processes to cut costs. Their average operating expense ratio has come down since last year, but investors feel there is still room for improvement. The lack of performance, the plethora of lower-cost alternatives and investors' increased confidence in trading on their own are prompting them to challenge fee terms.

Including management fees, the expense ratio has dropped from 1.95 per cent last year to 1.84 per cent this year as investors continue to apply pressure. Declines in management fees are driving this trend - average reported fees for this year were 1.35 per cent, down from 1.45 per cent last year.

Despite this downward trend, only 20 per cent of investors said they were satisfied with the expense ratios of their funds.

Managers have achieved significant operational cost reductions, but they agree that opportunities exist for further efficiencies. Nearly half of managers (44 per cent) reported actual or expected cost cuts in the middle and back office.

Investors are comfortable with outsourcing to further reduce costs, but managers aren't giving up control of certain functions. Almost 80 per cent of investors approved of outsourcing middle-office functions, but only 18 per cent of managers said they do so or plan to. Moreover, in the back and middle office, robotics and other forms of automation are creating efficiencies and driving savings necessary to counteract margin compression.

Managers are focused on developing their talent management programmes. Clients increasingly request details about such programmes at hedge funds - 75 per cent of investors indicated that they asked about this issue and made it a key consideration in their due diligence.

Although 52 per cent of managers were confident that client loyalty was rooted in strong relationships with the firm's founding principals, 55 per cent of investors stated that their primary allegiance was to their portfolio managers.

To bridge this disconnect between perception and reality, talent management programmes are evolving as managers focus on attracting and retaining the best people.

Mr Thung said managers should ensure that such programmes are appropriate for nurturing and retaining talented investment professionals. They should also ensure that they have succession plans for their portfolio managers.

A version of this article appeared in the print edition of The Sunday Times on December 04, 2016, with the headline 'Hedge funds must keep up with investor demands'. Print Edition | Subscribe