Changing investor demands are the top risk for the hedge fund industry, speakers at the EY Hedge Fund Symposium said Thursday, citing results from the firm’s latest global hedge fund and investor survey.
As poor performance, high costs and cheaper passive investment alternatives have depressed the industry’s growth, more North American investors say, for the first time since the financial crisis they are reducing rather than increasing allocations to hedge funds.
Those who do invest with hedge funds seek greater customization and increasingly prefer non-traditional alternatives, the survey found.
About half of all investors expect they will shift their hedge fund investments to other alternative investments over the next three to five years.
Investors show a broad appetite for real assets, private equity, long-only funds and best ideas funds, but so far only a small percentage of hedge funds is offering these products.
“We are seeing assets flowing to the managers that offer a wide array of non-traditional hedge fund products,” said Natalie Deak Jaros, EY Americas co-leader, Hedge Fund Services. “Managers that do not respond to changing preferences must ensure they offer something unique to potential investors.”
The largest managers are best placed to attract new capital since they are more likely to offer private equity, real asset strategies and best idea vehicles, she said.
Large funds are also in a better position to offer customized investment structures.
A growing number of investors, 42 percent, aim to shift from co-mingled hedge funds to customized vehicles and segregated accounts, which offer greater control, flexibility and a more intimate understanding of the investment strategy.
“Several years of an equity bull market and the rise of low-cost passive investment strategies have really encouraged investors to construct their own portfolios, which is limiting the use of hedge funds,” said Jeffrey Short, EY partner, Ernst & Young Ltd. (Cayman) and asset management leader for EY’s Bahamas, Bermuda, BVI and Cayman Islands practices.
Many investors such as U.S. pension systems have been investing in their own front office and have been trading for their own portfolios. These investors “have been turning to hedge fund managers to help them achieve specific exposures via customized solutions,” Mr. Short said.
Yet, only 8 percent of investors believe hedge funds can offer strategies or exposures that cannot be obtained elsewhere, the survey results showed.
The growing sophistication of investors is challenging managers to better explain how their offering achieves specific objectives in the investors’ portfolio. In addition, more investors are allocating to funds with tailored fees and liquidity structures as well as customized transparency and reporting.
Given that hedge fund performance is flailing and cheaper passive investments are more readily available, investors are also forcing managers to bring down their fees.
Average operating expense ratios in the industry have come down from last year.
Management fees, the main driver of the decline, have fallen from 1.45 percent last year to 1.35 percent in 2016.
Investors believe there is still room for improvement as only one in five are satisfied with the expense ratios of their funds.
Managers have looked to reduce operational costs through automation and outsourcing to alleviate some of the fee pressure. Nearly half of managers (44 percent) reported actual or expected cost reductions in the middle and back office.
While most investors are comfortable with further outsourcing, managers are reluctant to give up control over specific functions. For instance, only 18 percent of managers outsource middle office functions or plan to do so.
Still, automation is creating efficiencies around trade processing and cash management and generates savings to counteract margin compression in the back and middle office, the EY survey found.
Prime broker relationships
In a trend continuing from last year, prime brokers are re-evaluating who they do business with and how they are servicing hedge funds. Post-financial crisis banking regulations affect core financing, trading and prime broker activities for hedge funds.
Almost 60 percent of managers say their prime brokers have demanded fundamental modifications to their relationship to keep it economically viable.
Fund managers have responded by dealing with a larger number of prime brokers to meet their financing needs and manage counterparty capacity risks, according to the survey.