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5 Big Challenges Facing Hedge Funds

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Hedge fund managers and investors continue to face challenges arising from regulatory and cost pressures, new operational considerations and the war on talent.

A new report  from EY notes that even the definition of a “hedge fund” is being tested as segments in the financial industry blur and converge.

This has presented hedge funds with a significant challenge to brand themselves and their benefits clearly in the marketplace.

Indeed, brand is critical as new assets continue to flow to top-flight managers, both in hedge funds and broader asset managers.

At the same time, startup hedge funds are enjoying strong investor demand as well.

The investor base has changed dramatically from a decade ago, when two-thirds were high-net-worth individuals. Today, institutional investors dominate.

The way in which hedge funds are sold and distributed has also changed, and digital technology and social media will accelerate the process.

The importance of the client experience has been magnified. Today, global regulators are keenly focused on hedge funds’ alignment of interests with investors.

Greenwich Associates conducted 109 telephone interviews from June to September with hedge funds representing just over $1.4 trillion in assets under management. Research also included 57 telephone interviews with institutional investors representing nearly $1.8 trillion in assets, with roughly $413 billion allocated to hedge funds.

Following are five key challenges EY identified in the survey.

Focus on growth, but also on talent

1. Focus on growth, but also on talent

Hedge fund managers continue to cite growth as their top priority, although the proportion of respondents who did so in 2014 fell to 57% from 67% in 2013.

New growth methods include adding new strategies, identifying new investor bases and increasing penetration with existing investors.

According to the survey, growth occurs differently with each manager depending on where it is in its life cycle. Smaller and midsize startups seek to grow their client list and penetrate more investors with their core offerings.

The biggest managers, with a large clientele and established brand, look to expand their offerings, but now focus on cross-selling products and becoming a one-stop shop for investor needs.

To execute this plan, they are hiring top talent to focus on offering new strategies through traditional hedge fund products.

EY said this was in part due to mixed operational and financial results of launching new products, but also reflected changing demands of investors who want tailored exposure that align with their investment goals.

Adapt to rising fees and an evolving prime broker dynamic 

2. Adapt to rising fees and an evolving prime broker dynamic

Hedge fund managers are starting to feel the effects of recent bank regulations.

Regulations put into place since the financial crisis — particularly those resulting from the Dodd-Frank act and the Basel III conventions — have led to increased capitalization requirements, constraints on leverage and a focus on liquidity that have affected banks’ capacity and economics, resulting in an evolving shift in how prime brokers view hedge fund relationships.

Fifty-one percent of managers reported either higher fees from their prime brokers or an expectation of higher fees in the future.

Distressed securities strategies have experienced a 41% increase in fees, fixed income/credit a 32% increase, event-driven a 26% hike and macro a 24% increase.

This has caused managers to evaluate how they obtain financing and, in some cases, to make changes to their strategy.

Thirteen percent of respondents said they were seeking or planned to seek financing from nontraditional sources in the next two years, including from institutional investors and sovereign wealth funds, custodians or other hedge funds.

Support business functions with tech investments

3. Support business functions with tech investments

Seventy percent of managers surveyed expected to make major tech investments in the next two years, including investment management and trading operations, enterprise infrastructure and risk management systems. This represents a slowing pace from the 80% that invested in the previous two years; however, the magnitude of spending will increase.

Managers anticipated spending 12.4% of their budget on technology in the next three to five years, similar to the amount budgeted over the past two years, as they aim to develop robust infrastructures capable of supporting larger and more complex hedge funds.

Investment in data management and reporting technology is particularly crucial.

Twenty-six percent of larger firms, 45% of midsize ones and 48% of smaller firms said their technology environment needed improvement or further investment as it relates to data and reporting.


Outsource, but mind investor expectations

4. Outsource, but mind investor expectations

Across all asset classes, 60% of respondents currently outsource or are considering outsourcing certain middle-office functions. Only 27% of smaller managers, however, report they are currently outsourcing or considering it.

Investors generally report more comfort with outsourcing than hedge funds themselves, with 91% saying it was acceptable in in OTC services (91%), 89% in pricing/valuation and 87% in confirmations/affirmations and settlement.

Investors are least receptive to outsourcing hedging, with 60% approving, and cash management, with 64% approving. EY cautioned, however, that managers should not resist outsourcing because they believe investors are uncomfortable with it.

The survey found investors satisfied with the benefits that managers had derived from using third parties for a majority of back-office functions. They now encouraged their managers to be opportunistic in expanding to utilize specialists in performing as much of the middle office as possible.

Make transformational changes

5. Make transformational changes

The survey found that larger managers realize they must view themselves as alternative asset managers and offer multiple product types and strategies to meet investor needs.

Fifty-four percent of this group currently considered themselves multiproduct asset managers, and 63% thought they would be in three to five years.

Forty-seven percent of midsize managers reported that they currently offered only one product, but 49% hoped to emulate their larger counterparts by becoming a multiproduct asset manager.

The smallest managers continue to fill a niche, and have more tempered expectations about where their organization will be in the near future, with just 19% seeing themselves as multiproduct asset managers.

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