Despite increasing regulation, pressure on fees, and a flood of new products competing for investor dollars, hedge funds are finding new ways to grow in 2015. The dynamics of the industry are evolving – and that evolution is the focus of EY’s 2015 Global Hedge Fund and Investor Survey.
Different Paths to Growth
“Seismic shift” and “profound transformation” are words EY uses to describe the hedge fund industry in recent times. But the turbulence of the past few years has also opened more paths to growth than ever before. “Efficiency is the name of the game,” according to EY, and “embracing technology and data optimization is the new imperative.”
Hedge funds are in all four stages of “basic economic business model” evolution – startup, rapid growth, maturity, and decline – and funds at different stages are embarking on different paths to growth. Startups, for instance, are focused on asset growth, while mature firms – those with large clienteles and established brands – are focusing on cross-selling products and becoming a “one-stop shop” for investors.
As a result of these shifting dynamics, the percentage of managers that said “growth” was their top priority fell from 67% in 2013 to 57% this year. Larger managers are becoming “alternative asset managers” rather than strictly hedge funds, and offering multiple product types and strategies: 54% of respondents said they now consider themselves “multi-product asset managers,” and 63% feel they will be in three to five years.
Hedge funds not only face direct regulatory scrutiny, but they also suffer indirect effects from increased regulation of other areas of the financial sector. For instance, Basel III and Dodd-Frank have increased the importance of liquidity for banks and prime brokerages, and this has led those institutions to increase their fees. Twenty-nine percent of the EY survey’s respondents said their prime brokers hiked their fees over the past year, and 22% said they expect an increase within the year to come.
“As many prime brokers have less capacity to offer than in the past, hedge fund managers are increasing the number of relationships they have to reduce counterparty capacity risk,” said EY’s Natalie Deak Jaros, Co-Leader of Hedge Fund Services for the Americas, in a recent statement. “We are also seeing the need for hedge funds to dedicate individuals to manage counterparty risk, collateral and treasury functions as a result of these shifting industry dynamics.”
Nontraditional Financing Sources
Higher prime brokerage fees are pushing some hedge funds into nontraditional financing sources. Thirteen percent of respondents to EY’s survey said they are looking or plan to look for financing from nontraditional sources in the next two years. These sources include institutional investors, sovereign wealth funds, custodians, and other hedge funds.
“All forms of financing are becoming more expensive for a majority of managers, and these costs have a direct effect on overall trade economics,” said EY’s Global Leader of Hedge Fund Services Michael Serota. “Investors will be indirectly affected by the increasing costs and will need to rely on communications from the manager to understand the full effect on the fund’s performance.”
Seventy percent of respondents said they expect to make major tech investments in the next two years, indicating technology investments are becoming more essential to support business functions. Outsourcing has become key, too: 60% of respondents currently outsource or are considering outsourcing certain middle-office functions.
Beyond upgrading tech and outsourcing to specialists, what can hedge funds do to address some of the challenges outlined earlier? According to EY, hedge funds should:
- Adjust to operating with lower margin expectations;
- Clearly define their value propositions;
- Refine client segmentation strategies to enhance their brands;
- Simplify their business to focus on core products; and
- Focus on outcomes, not only returns, by committing to an overt alignment with investor interests.
For more information, download a pdf copy of the white paper.