If any doubters remain, they are few and far between. The hedge fund world, even before the imposition of wide-scale regulation and oversight, has fundamentally changed. How the industry will develop, however, is not certain.
Several interesting influences and trends are present. And while there is a lot of talk, it is not always clear if that has or will translate into reality.
First is the question of fee structure. At the start of the year, the general consensus seemed to point to a radical change in fee structure with some predicting more of a private equity-style look to hedge fund fees. That has clearly not happened. However, there is obviously something going on with fees. It is obvious investors will continue to pay for what they perceive as quality. Good managers are still demanding and receiving a premium.
There seems to be some shift towards a more subtle and fluid structure. Start-ups have management fees ranging from 0.5-3%, with performance fees as low as 10% and up to over 20% for some funds. Recent research suggests the average management fee is now under 2%, although it is not clear if funds will be able to sustain such a low figure given the increased costs of running a fund and the likelihood that regulatory compliance will put further financial cost pressures on funds of all sizes.
Atlantic Split
Related to the fee structure is the seemingly growing division between US- and European-based funds. US managers continue, for one thing, to cling to the “2 and 20” model while Europeans appear to be a bit more pragmatic (or populist) and have on average lowered their fees.
There are further differences. European managers, long used to registration and oversight, are continuing to move into regulated products. Although they are still opting for an offshore fund, many are creating mirror-image regulated funds either under the UCITS brand or fully-fledged retail funds. This is another canny move by the Europeans. At one stroke, a fund manager with a regulated product opens the door to a new set of investors and at the same time, can righteously point to the fact that regulation is not a problem.
On the other side of the Atlantic, fund managers cling to the hope of escaping the watchful eye of regulators and are still favouring the Cayman Islands master/feeder structure – at least for the moment. There are signs that some funds may be using the same trick as the Europeans and creating mutual fund structures. There are also reports of US fund managers setting up within Europe in order to take better advantage of the UCITS rules.
While the regulatory Sword of Damocles still hangs over the European fund industry in the form of the EU's draft directive on alternative investment fund managers, the industry has already taken steps to heal the rift between investor and fund and ironically, neutralise the main criticism of hedge funds – their secrecy and opaqueness.
More transparency, allowing investors to see, in some cases, real-time portfolio trading, more disclosure of positions as well as clearer risk reporting to investors, are just some of the steps already taken by funds across the board.
While some are still reluctant to embrace the new paradigm, the majority are heeding their investors and being more open about what they do and how they do it. Certainly, communication still needs to improve markedly between funds and investors but at least it is a start.
The other elephant in the room between funds and investors is the question of liquidity. Again, whether pushed into it by investors or by design, more funds are offering better redemption terms and being realistic about what kind of liquidity they can offer, based on the types of assets they trade and hold. Investors who understand the nature of more long-term holdings and illiquid instruments are still willing to support funds as long as the terms reflect reality and not wishful thinking.
Another interesting change to the industry, which is still more of a hint of promise than a substantial reality, is the growth of the funds industry in the Far East. As more Chinese funds open in Hong Kong in order to take advantage of the wider range of instruments available on the stock exchange there, there are hints that the industry could emulate the Chinese talent for growth. As 'sea turtles' (emigrants who return to China) become more numerous, the industry could grow rapidly.
Meanwhile, growth remains slow but steady in other areas where hedge funds could take a bigger share of the alternative investment industry. (Certainly, Mauritius is continuing to expand.) On the other side of the world, Brazil and South America in general is another area to watch, particularly as wealthy individuals and institutions in that region begin to look into alternatives.
Service Developments
In the midst of all these changes are equally important developments in the services supporting the industry. Prime brokerage, for one, is certainly in flux. As new entrants emerge (like HSBC) and others jockey for greater market share (like Credit Suisse and BNP Paribas) in a multi-prime world, the surfacing of the mini-prime could also impact in some very positive ways, most obviously on pricing and better-quality servicing.
Fund administration also looks set for a bit of shake-up. As a recent survey has revealed, most of the top players have seen assets under administration (AUA) plummet (in line with the fall in assets under management by funds). How quickly they can recoup these losses is an open question. Administrators must also be asking whether now is the time to start moving towards a different fee structure not based on AUA, given that the amount of work stays the same even when AUA falls. Whether a change will be possible or practical remains to be seen.
With funds looking to outsource non-core functions, administrators, custodians and prime brokers all see opportunities. A lot of the advancement in this area is due to the technological developments that are transforming the way funds communicate with their service providers as well as investors. New technologies are also helping to change the way funds (and funds of hedge funds) report, evaluate and monitor risk, trade faster and smarter and in general improve a wide range of functions.
Providers who are not burdened with legacy systems but have the ability to be flexible and nimble in adopting technological advancements and enhancements will probably go further faster.
Every aspect of the hedge fund landscape seems to be in some state of transition or evolution. In the midst of such uncertainty about almost every aspect of the industry, one thing seems to be without question - it will survive and thrive.
This article first appeared in www.hedgefundsreview.com on 1 August 2009.
