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Six ways hedge funds need to adapt now

By Ross Ellis, Vice President

SEI

Q2 2013


Where are we today?
It has been nearly five years since the financial world was turned upside down. The events of 2008 and their aftermath are burned into the memories of asset managers and investors alike. For those who are still in the process of recouping their losses, the pain is all too present. 

For the hedge fund industry, 2008 looms even larger as a watershed year.  It’s not that clients exited en masse, or that hedge funds suddenly lost their touch. A year earlier, even though investors had long been disabused of the notion that hedge funds could be relied upon for positive returns every year, their role as portfolio diversifiers seemed secure. “Two and twenty” was the industry-standard fee, clients assumed their hedge fund investments would add value over time, and liquidity restrictions were accepted as part of the price for access to exceptional investment talent. 

What a difference five years makes. After the financial crisis, any lingering feelings of complacency among investors dissolved. No longer is it assumed that a hedge fund will deliver unequivocal portfolio value, even if it can tout a good track record. And no longer can managers simply “show and tell.” Now investors want proof; they also want to “look under the hood” to funds’ inner workings and judge for themselves.

Key challenges and action steps
To explore what directions the industry is taking now, and how hedge fund firms can better equip themselves to succeed, SEI complemented this year’s global survey of institutional investors – our sixth annual – with wide-ranging roundtable discussions among top hedge fund practitioners in both New York City and London. Organized and moderated by Rachel Minard, CEO of Minard Capital, an outsourced marketing consulting firm, consultants and industry advisors were also represented, giving us a broad perspective on the future of the industry. On some topics, such as the need for hedge funds to provide proof of the value they deliver, we found strong consensus; on others, there was a sometimes surprising divergence of opinion — more evidence of the complexity and continuing evolution of today’s industry climate.   

Entitled “6 Ways Hedge Funds Need to Adapt Now,” the study1 identifies key challenges hedge fund firms must meet if they hope to succeed in the long term:

  • Sustainable edge. With 7 in 10 survey respondents asserting that “there are too many look-alike strategies in the industry,” institutional investors are raising the bar for manager selection. To be competitive, hedge fund firms should focus on articulating a differentiated investment approach, a clear process, and proof that their edge can be sustainable.   
  • Adaptability. Roundtable participants noted that the combination of converging investment structures, shifting investor demands, and challenging market conditions are causing hedge fund managers to rethink their business models and develop multi-faceted solutions that package their capabilities most effectively.  
  • Clear value added. Investors are increasingly concerned with how much “true alpha” they are getting for the hedge fund fees they pay. While most of the institutions surveyed are still planning to maintain or modestly increase hedge fund allocations, only 38% reported being satisfied with risk-adjusted hedge fund returns, down from 62% a year ago. Moreover, fewer than four in ten believe that they would be unable to meet their investment objectives without using hedge funds.  
  • The right fit. Today’s investors have complex needs and want hedge funds to serve multiple objectives within an overall portfolio mix.  Poll results suggest that rather than “pitching products,” fund managers should use an interactive, problem-solving approach to match their capabilities to investors’ specific objectives. It also calls on institutional investors and consultants to develop clear, focused mandates based on realistic expectations.   
  • Scale or sizzle. Size presents challenges and opportunities at either end of the hedge fund scale.  While large funds still attract the majority of institutional assets, and have advantages in building institutional-quality processes, their performance has collectively lagged that of smaller funds.  Meanwhile, while small funds may be better equipped to offer competitive returns, emerging strategies, and undiscovered investment talent, they often fail to pass the screens consultants frequently employ when selecting managers.   
  • Business and marketing acumen. Roundtable participants resoundingly agreed that running a sustainable hedge fund business is as difficult as achieving strong investment performance.  Notably, participants also felt that asset growth often depends less on investment performance than on effective marketing and sound business management. Managers need to make strategic use of outsourcing, adopt marketing best practices, and invest more on compelling client communication in order grow their businesses.    

Conclusion
When all is said and done, the hedge fund industry is here to stay. Exceptionally talented investment managers with original investment ideas will continue to seek the flexibility and opportunity that the hedge fund structure provides. Likewise, institutional investors will continue to want access to that top talent, and to differentiated alpha-generating strategies and return streams.

At the same time, the industry’s value proposition is being seriously questioned, and institutions continue to escalate their demands for transparency and intensify their due-diligence processes. There is no doubt that today’s climate of slower economic growth, low yields, elevated asset-class correlations and more competition makes it harder for hedge funds to live up to their past outperformance. It comes as no surprise that hedge fund managers increasingly object to studies and media reports that view the industry as monolithic, painting widely variegated strategies with the same broad brush of underperformance.  Some see the institutionalization of hedge funds over the past 15 years as a double-edged trend that may hinder performance even as it brings more discipline and accountability to the industry. 

The full report highlights many areas of potential change and improvement in hedge fund practices and client relationships but the overarching message that emerges is one centering on the need for better understanding among hedge fund management firms and institutional clients. Better-written mandates, more fully articulated investment processes, and added documentation may address symptoms of the industry’s current problems. Only through unhurried, unfettered and ongoing dialogue can true alignment of fund managers and investors — and truly successful relationships — be achieved. 

 

[1] To request the full paper, visit www.seic.com/SixWays.

 

rellis@seic.com
www.seic.com/ims

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