As hedge fund managers rethink their products, fee structures and markets to refocus on institutional investors long-term impacts will be significant for both hedge funds and their investors.
Recent evidence suggests that most hedge fund managers now believe that institutional investors, in particular pension funds, will soon become their largest investor group. Indeed, according to a recent report published by KPMG, the Alternative Investment Management Association (AIMA) and the Managed Funds Association (MFA), most managers expect to see a significant shift in their primary sources of capital over the next five years, away from corporate pension funds and high net worth investors, towards public pension fund managers.
Although most pension fund managers appear committed to maintaining alternative investments as part of their investment portfolio, hedge fund managers will need to dramatically change their models, structures and products.
To start, hedge fund managers will need to rethink whether their current fund strategies are suitable since many institutional investors have focused on cutting their investment management costs. In some cases, pension funds have conducted a general consolidation of investments towards a smaller number of large (and, therefore, presumably less risky) managers.
For other pension fund managers, cost cutting has focused on negotiating more flexible fee arrangements. Hedge fund fees seem set to fluctuate since the vast majority of hedge fund managers expect to compromise on fee arrangements over the next five years.
Hedge fund managers will also find that pension funds are increasingly focusing on securing highly customized products – such as funds of one and managed accounts – rather than participating in co-mingled funds and limited partnerships.
Over the next decade, we expect to see customization become increasingly commonplace in the hedge fund sector with investment managers becoming less concerned about the specific asset class they are buying, preferring instead to focus on whatever asset class will provide the right risk, fees and returns to fill specific gaps in their portfolios.
Fund managers will also be forced to rethink their hedge fund performance targets and reporting processes since public and corporate pension funds and most sovereign wealth funds demand significant transparency from their managers. Interestingly, greater participation by institutional investors may also change the return profile of the industry as pension funds opt for lower-volatility and more stable returns.
With larger pension funds and institutional investors now tending to cap their investments as a certain percentage of the manager’s total assets under management (AUM), many smaller managers may not be able to compete on their own for a share of the anticipated institutional investments.
Platforms seem to offer a strong solution for both smaller hedge funds seeking to attract institutional investors and for institutional investors looking to tap into new sources of talent. Most of today’s platforms provide a full suite of investor services, making it fairly easy for institutional investors seeking to reduce complexity.
With the hedge fund sector in the midst of an era of unprecedented change, we believe that assets currently considered as ‘alternative investments’ will soon become more mainstream as products become more available across multiple platforms and through to retail investors. When combined with the cost of regulation, we expect to see increased use of technology as smaller funds band together to achieve the mass they require to attract institutional investors.
We believe that the increasingly rapid shift towards pension funds, in particular, will catalyze significant changes in the way that managers structure, manage and market their products in the long-term. This will require managers to think seriously about their business models and fund strategies going forward.
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