Three Strategies That Could Shape Hedge Fund Growth

Although the hedge fund industry faced a number of challenges last year, from market volatility to increased regulatory scrutiny, it also reached an important milestone, surpassing records set in 2007 for assets under management (AuM) and absolute number of funds.¹ Those hedge funds around during the last peak have settled into a more measured and sustainable pace of growth, with money flowing mainly to hedge funds that adjusted to regulators’ and investors’ demands for more transparency while looking for new ways to streamline back-office operations.

There are challenges ahead for the industry, however. With SEC registration now behind them, hedge funds will be subject to Form PF reporting on an ongoing basis and, for the first time, risk-based examinations. Many are also facing growing demands from institutional investors, which are making their mark as an increasingly vocal client base. On the investing front, client appetites for alternative investments continue to increase as bond yields hover near all-time lows, public pension underfunding approaches record levels and equity market volatility upends more traditional investments.

Three strategies are expected to shape the industry’s approach to these and other issues this year:

—Fostering a compliance culture

—Competing for new assets with targeted strategies

—Addressing fee pressure through operational streamlining

1. Fostering a Compliance Culture

Compliance has become a top priority for hedge fund executives given the increasing regulatory burden and push by investors for additional transparency. The implications of new rules stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the Foreign Account Tax Compliance Act (FATCA) and the Alternative Investment Fund Managers Directive (AIFMD) are far from settled. There is a general recognition among hedge fund leaders, however, that they need to fortify their compliance policies, procedures and personnel in order to stay agile and responsive in this dynamic regulatory environment. This awareness extends to the need to ensure that hedge funds maintain adequate oversight of service providers, who are taking on more responsibility in performing regulatory functions.

Outlook

With more than 1,500 new private fund advisers registered with the SEC in late 2012, hedge funds opened their doors in 2013 to the new SEC inspection regime.² In advance of these risk-based “presence exams,” the SEC has told fund advisers that it will be focusing on five key compliance areas: marketing, portfolio management, conflicts of interest, the safety of client assets and valuation.³ “Some in the industry have expressed concern about the agency’s sophistication when it comes to hedge funds, but we believe regulators have strengthened their hand by enhancing their capabilities in some important ways,” says Cary Stier, vice chairman and U.S. managing partner for the Asset Management Services Group, Deloitte LLP. “SEC examiners are increasingly incorporating data analytics to identify aberrational trading or performance and detect instances of insider trading.” He also expects the coming months to bring increased clarity on several other compliance-related topics among hedge funds, including FATCA, Commodities Futures Trading Commission registration, AIFMD and tax reform. In addition, institutional investors are likely to expand their demands for greater transparency into new areas such as cybersecurity and fraud prevention programs.

Bottom Line

Given the reputational harm that can come from an enforcement case, compliance is now a critical component of a hedge fund’s culture, perhaps as important to their survival as investment performance. This year will bring increased emphasis on managing the compliance burden in a manner that integrates governance, controls, supervision, operations and technology. “A dedicated chief compliance officer is suggested for firms that have registered or plan to register with the SEC in 2013,” notes Jim Eckenrode, executive director of the Deloitte Center for Financial Services at Deloitte Services LP. “A chief financial officer or chief operations officer might have been able to handle the added responsibilities before, but those days are clearly over.”

2.  Competing for New Assets with Targeted Strategies

Despite the increased scrutiny from regulators, the industry’s AuM broke through the $2 trillion barrier and may be poised to rise even higher as institutional investors shift more of their investments toward risk-driven classifications and increase their alternative asset allocations. Still, the industry’s relative underperformance during the last few years has some investors questioning the value add of hedge funds and they are exerting downward pressure on fees as a result.

“Two-and-twenty” is no longer sacred, and fee flexibility is becoming the new normal. For certain, some hedge funds will inevitably generate outsize returns in 2013 and offset these kinds of pressures, but the search for alpha will likely remain elusive for most.

Outlook  

The balance of power may remain in the hands of investors, but alternative investments could be an area of opportunity for hedge funds this year, specifically those with diverse investment capabilities and robust operational infrastructures. ”We expect certain big-ticket institutional investors  to seek more customized solutions, including investment and co-investment strategies,” adds Mr. Eckenrode. “Some of those might require tailored reporting capabilities and managed account platforms on the part of the funds.”

Additionally, resolution of challenges tied to the JOBS Act may give hedge funds access to high-net-worth individuals through wealth management platforms. A positive ruling could reshape the way hedge funds market and attract new assets. These diversification strategies should continue in the remainder of the year, with some firms expanding geographically, into emerging or even frontier markets, or into new asset classes such as European credit. Alpha opportunities may also be found in certain asset classes such as real estate or distressed debt. Other opportunities could include generating alpha through niche strategies such as structured credit, frontier market debt or other illiquid fixed income instruments.

Bottom Line

Large hedge funds are, in some cases, better positioned for growth this year as they are able to leverage broad-based competitive advantages across investments, distribution and operations. However, in an industry where performance ultimately drives success, scalable smaller managers and niche hedge fund strategists should have plenty of opportunities.

3.  Addressing Fee Pressure through Operational Streamlining

With limited top-line growth and operational costs creeping higher, hedge funds are searching for productivity gains. Compliance costs are rising, institutional investors are increasingly seeking customized service levels and alpha generation has grown more challenging. “We see the year shaping up as one in which hedge funds consolidate these efficiency gains while they dig deeper for cost-cutting opportunities,” notes Mr. Stier.

Outlook

More hedge funds will likely turn to outsourcing, process efficiencies, enhanced data management and technology solutions to help alleviate operational strains involving regulatory initiatives, compliance programs and middle office functions such as trade processing and corporate actions processing. “While retaining oversight responsibilities in-house, hedge funds will turn to new outsourcing models that transfer resource-intensive operational, regulatory and technology activities to external partners with scale advantages,” Mr. Stier observes.

The industry’s views on technology will also continue to evolve, as more chief information officers embrace ways to reduce costs and risks by better integrating service provider connectivity, enhancing risk analytics, leveraging data management and offloading certain commoditized trading activities, among other opportunities.

Bottom Line

The increasing regulatory burden, combined with investor pressure to provide greater transparency and reduce fees, amounts to a new operating reality for hedge funds. It may be difficult for all but the largest funds to justify the investments needed to sustain an institutional-grade operation while confronting more operational demands. Ongoing industry consolidation is one ramification of this difficulty. Some may be able to alleviate this pressure and level the playing field by turning to partnership strategies that incorporate a blend of outsourcing and technology.

Endnotes

1. As per HFR as of 2Q12.

www.sec.gov/news/press/2012/2012-214.htm.

www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.

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