Six trends present important opportunities and challenges for hedge funds.
Blurring of the Lines. The lines that have traditionally distinguished hedge funds from their clients and competitors in adjacent spaces are blurring. Hedge funds’ largest clients, such as sovereign wealth funds and pension funds, are becoming more sophisticated, often using the same tools and technologies as hedge funds to execute their own investment strategies. Some clients are partially bypassing hedge funds, and some are seeking different arrangements with them. In a growing market, this trend may have a limited effect on hedge funds, especially the most sophisticated. In a flat or shrinking market, however, the consequences could be profound.
At the same time, competitors from adjacent spaces increasingly compete on hedge fund turf. Fifteen percent of the top four private equity funds’ AuM is now in hedge-fund-type investments. Asset managers are also encroaching, by investing directly in liquid alternatives or by acquiring or partnering with hedge funds.
Of course, the blurring of traditional lines also creates opportunities for hedge funds. Banks and broker-dealers are responding to burdensome new regulations and reduced returns by contracting their capital market offerings. This gives hedge funds the opportunity to enter new lines of business, such as lending, market making, and asset servicing.
Technological Arms Race. AuM in hedge funds reached $3 trillion in 2016, having increased by 150% since 2011. This new scale has made it harder for hedge funds to operate only in investment niches where they can generate alpha and to differentiate themselves from competitors. To stay ahead, leading hedge funds increasingly rely on superior technologies that provide access to new sources of data and the most advanced analytical and decision-enabling techniques.
Gaining access to the best technical expertise, however, is no longer a given for hedge funds. In the post-financial-crisis world,
the talent that once went directly to hedge funds is instead going to leading technology companies, fintechs, and other digital startups. The finance industry is suffering from a damaged reputation and the perception that it is no longer “where the action is.” Ambitious and inspired graduates have shifted their gaze from Wall Street to Silicon Valley.
Increasing Complexity. Running a hedge fund is an increasingly complex business. Clients are becoming more sophisticated and demanding. They expect better value: tailored advice that goes beyond investing in the fund, bespoke mandates, more-
differentiated investment strategies, and greater transparency. Competition to find new sources of alpha is driving hedge funds toward illiquid and private assets, putting further pressure on already strained technology and operations. And postcrisis regulation continues to grow in both volume and stringency, creating new compliance costs.
Fee Pressure. Hedge funds now face a buyer’s market in which large-asset owners are exercising their bargaining power. Many no longer pay hedge funds the traditional “2 and 20” but instead come to individual arrangements. Indeed, some funds have eliminated management fees altogether, relying entirely on performance fees. At the other end of the spectrum, funds that invest in liquid alternatives—promising returns similar to those yielded by traditional hedge funds (but, arguably, not yet delivering them)—are charging low or even no performance fees and management fees well below 2%.
Continued Low-Yield Environment. With returns from traditional asset classes muted, investors continue to turn to alternative asset classes for the returns, diversification, and levels of risk balancing they require. Because many asset owners must meet a liability target, hedge funds have the opportunity to participate more actively in the growing solution space (outcome-oriented investment, such as target date funds), whose AuM reached $9 trillion in 2015.
Market Concentration. Institutional investors favor “big name” hedge funds, seeking security in their reputations and historical performance. As the hedge fund market matures and more institutional money flows in, the top players are picking up a disproportionate share of the business. At the end of 2008, hedge funds with AuM of more than $5 billion accounted for 56% of all industry assets; by the end of 2015, the figure had risen to 71%.