The hedge fund industry is in the midst of a transformation. The growth environment is constantly changing and, as a result, managers have become more focused than ever on improving operational effectiveness, increasing alignment of interest and delivering value to their investors. New strategies, new investors, new markets and new (and often more customised) products and services are changing the market dynamics.
We see the evidence of change all around us. It is in the growing influence of institutional investors and the rapidly emerging markets. It is in the shift towards customisation of products and fee structures. And it is in the macroeconomic trends that continue to buffet our industry. To better understand how all of these changes are impacting managers around the world, KPMG partnered with the Alternative Investment Management Association (AIMA) and the Managed Funds Association (MFA) to undertake a comprehensive survey, both online and in person, of hedge fund managers.
We believe that – particularly in this time of rapid change – it is critical for our industry to share experiences, insights and leading practices. If we want our industry to grow (both in terms of total assets under management (AUM) and number of managers), we will need to break down barriers and adjust our strategies to continue to thrive.
This year’s Global Hedge Fund Survey looks at the impact that this change is having on virtually every aspect of hedge fund management, from product mixes and fee structures through to markets and investor types, and provides keen insights gathered from our one-on-one interviews with some of the industry’s largest and most successful fund managers.
Partner, Global Head of Hedge Funds, KPMG in the US
Richard H. Baker
President and CEO, MFA
We are living in an era of unprecedented change. But it is not just the world around us that is evolving; so too is the alternative investment industry itself. Indeed, a new environment is now emerging for hedge funds, and most managers believe they will grow upwards as a result.
As this report illustrates, the industry, which has seen AUM grow by approximately 10% a year since the financial crisis, is positioned to continue along this growth path over the next five years. Institutional investors, who already account for roughly two-thirds of the total hedge fund capital, will continue to eclipse high-net-worth individuals as the industry’s primary sources of investment. Traditional fee arrangements will erode in the face of more customised models. And new markets will emerge both as investment destinations and as potential customers.
The increasingly rapid shift towards institutional investors, in particular, will catalyse significant changes in the way that managers structure, manage and market their products. The customisation of fees and products – a trend already well underway – is just one strategy that managers are taking to attract institutional investors.
Other growth opportunities are also emerging. Many managers are starting to shift their attention towards new and growing markets. Others are customising their products – and increasingly their services and strategy – to broaden their appeal. The growing adoption and development of liquid alternative products such as ‘40 Act and Undertakings for the Collective Investment in Transferable Securities (UCITS) funds shows that demand is shifting.
The impact of new regulation remains a concern. As in the past, managers suggest that the growing regulatory burden is creating significant barriers to growth in most markets. Many say they expect the number of managers to shrink overall as a result.
Among our key findings:
THE GLOBAL ECONOMIC OUTLOOK: AT THE NEXUS OF AGING AND ALTERNATIVES
Two major factors seem set to influence the alternatives funds industry over the coming years: the state of the US economy and the impact of an aging world population. To help explain the impact these trends will have on the industry, we asked Constance Hunter, chief economist with KPMG and recognised alternatives expert, to provide her perspective on what lies at the nexus of these evolving trends.
What is the link between aging and alternatives?
Investors should be interested to know that the average age of the planet’s population is increasing by six hours every 90 days or so – simply put, the world population is living longer. And while nobody is about to complain about living longer, the reality is that living longer is not free. In developed economies, it usually means more years in retirement and, as a result, a growing attraction to assets that generate low-volatility returns for longer periods of time. This metaphysical aspect of living longer has clear implications for how economies, markets and – in turn – asset allocations, will adapt. It is highly likely that hedge funds will play an increasingly important role in providing better diversification with greater liquidity when compared against other alternative investments such as private equity, infrastructure or real estate.
Do you see US growth continuing?
To understand the US growth picture, one needs to look more globally since much will depend on the global economic outlook and environment which, in the developed economies, is largely characterised by low bond rates: Japan has 10-year bond rates of just over 0.3%; Germany’s is 0.5%; the UK, 1.6%; Italy, 2.9%; and the United States, 1.8% (which, when one considers that US 10-year rates averaged 6.48% over the last 50 years, is remarkable).
At the same time, the October 2014 International Monetary Fund (IMF) report downgraded growth for most economies, developed and developing alike. But the current economic outlook for the US is substantially stronger than the rest of the developed market economies, reflected in the fact that the IMF report also upgraded US growth projections by 50 basis points to 2.2% (year over year) in 2014 and 3.1% in 2015. In fact, more recent US data shows that growth has actually been stronger than expected, and suggests that the US economy will grow between 20-70 basis points more than the IMF’s original projections.
Do you think that the US economy will decouple and lead the world out of its economic malaise, or will the decline in growth in Europe, Japan and select emerging markets be severe enough to derail the US economy’s momentum?
My bets are on decoupling. In part, this is because the US only derives around 12% of its GDP from trade, most of it with the North American Free Trade Agreement (NAFTA) and Europe. So the global economy would have to get significantly worse to bring the US growth rate down by more than 20-30 basis points in 2015.
Over the past year, the slowest growth in the world’s developed economies has come from Japan and select European economies. Yet clearly the recent mild recession in Europe and scant growth in Japan has not stopped the US economy from gathering steam over the past two years. (It should be noted that the current outlook for both Europe and Japan is for those economies to improve slightly over the next year as a combination of monetary stimulus and structural reforms promote growth in final demand). In the case of Japan, the fall in oil prices will help stimulate greater consumer spending and help the economy’s trade balance as Japan imports nearly 100% of its oil.)
The last two years have also delivered an ever-increasing growth rate to the US economy. This is especially evident in the labour market, which added 27% more jobs in 2014 than it did in 2013. And while the average weekly earnings rose only 2.1% in 2014 and the participation rate fell from 63.2% in 2013 to 62.9%, there are a number of other economic indicators such as capacity utilisation, services consumption, and investment figures which grew at levels consistent with an accelerating growth trajectory.
Other factors are also suggesting that the US will decouple and continue to grow. Gasoline prices at the pump averaged $2.48 for the month of December 2014 versus $3.34 for the year (falling 39% from their high in April 2014). Meanwhile, 10-year interest rates have been capped by low global rates and — while rates may have touched 2.99% on the first trading day of 2014 — they ended the year at just below 2.0%.
Similarly, 30-year mortgage rates averaged 4.4% in 2014 and had fallen to around 4.1% at the start of 2015; this has allowed mortgage interest as a percentage of wages to fall to its lowest level since that data became available in the early 1950s.
Based on this improved economic outlook and stimulative factors such as low interest rates and low gasoline prices, I think it unlikely that poor growth in other developed economies will bring down US growth by very much. In fact, it is possible that the resultant lower interest rates and gasoline price will more than make up for the drag from potentially lower exports or a stronger dollar. And in turn, this could have a similarly stimulative effect on the US’s trading partners’ economies, especially those that import a significant percentage of their petroleum products.
If the US seems set to decouple, what of the impact on the rest of the world?
A good way to explore this is to measure the impact of final domestic demand (this is final sales to businesses, consumers and the government) on “value added” in foreign economies. According to recent research by Wells Fargo economist Jay Bryson, the US has a larger influence than China on Asian economies, and a significantly larger impact on the European Union (EU) and the NAFTA region. Its influence in Latin America is only slightly greater than China’s, as China’s recent voracious appetite for commodities has fueled demand from the region’s many commodity-rich countries such as Brazil, Chile, Bolivia, Ecuador and Mexico. Even so, the US accounts for about 2.6% of global value added compared to China’s 1.6% contribution.
The good news for the global economy is that the US and China are likely to continue posting positive growth in the near future. Even if China’s economy slows to the more bearish predictions of a 4.0% growth rate from the current 7.3%, it will still be making a positive contribution to global final domestic demand. Thus, relatively stronger US growth will likely help stimulate exports for weaker developed economies, thereby also making a positive contribution to their growth.
The outlook for the US and the global economy will also be influenced by central bank action, with the European Central Bank and Bank of Japan each pledging to proceed with aggressive quantitative easing (QE) programmes. If the full $1.7 trillion of QE planned by these central banks materialises between now and the end of 2015, it will serve to keep global interest rates lower than they would have otherwise been. Ultimately, the relatively higher US rates, in turn, attract fixed income investors from around the world, thereby keeping US rates low despite stronger growth and the Fed exiting QE.
But what does all of this tell us about the impact of aging demographics?
I believe that changing demographics will have a significant impact on the asset management industry, and hedge funds in particular. Conventional wisdom suggests that, as investors age, they allocate a greater portion of their portfolio to fixed income assets as, historically, they deliver a more predictable (albeit lower) return stream with much lower volatility than other types of investments such as equities or even real estate.
However, as people start to live longer, they will also start looking for greater return and low volatility. While modern portfolio theory has come under fire since the global financial crisis due to many asset classes becoming highly correlated in times of global systemic stress, it does suggest that diversification of different assets that perform differently from each other can help investors weather minor market storms and can improve compounding by reducing drawdowns in portfolio assets.
Thus, it stands to reason that an aging population experiencing greater and greater longevity will — by increasing its allocation to bonds — push down yields, thus reducing returns which thereby creates demand for a wider variety of assets to help diversify portfolios in an attempt to reduce volatility and improve compounded returns.
This need for diversification is likely to continue to drive allocations to alternative investments, and hedge funds are an important part of that alternatives universe. They can be used to increase allocations to fixed income without taking duration risk; they can be used to gain exposure to commodities that are not constrained by the near contract rolls that exchange-traded funds (ETFs) are subject to; and they can provide almost every stripe of exposure to equities on both the long and short side.
In a recent study by Cerulli, 72% of respondents cited the need to optimise risk-adjusted returns as the primary reason for increasing their allocation to alternative assets. Given the current global economic outlook and the trend towards increased longevity, it seems clear that diversifying portfolio allocation still has more time to run its course and hedge funds will be a primary beneficiary.
NEW INVESTORS CHANGE THE DYNAMICS
While high-net-worth individuals were once the “bread and butter” of the alternative investment sector, our survey demonstrates that most managers are expecting that institutional investors will drive their long-term growth. At the same time, the demographics of investors are also shifting and diversifying. Clearly, the dynamics of the market are about to change.
The fact that investor demographics and types are changing should come as no surprise to managers around the world. Indeed, according to our survey, most managers are expecting a significant shift in their primary sources of capital over the next five years. Today, the vast majority (80%) of managers say that their funds include some capital from high-net-worth investors; almost two-thirds (63%) include capital from family offices which, arguably, operate similarly to the high-net-worth category. Barely half (54%) say they already manage capital for corporate pension funds, while 42% boast investment from public pension funds.
Interestingly, funds in Asia-Pacific seem to have been the most successful in attracting institutional investors to date: almost three-quarters (72%) say they manage capital for corporate pension funds and more than half (52%) count sovereign wealth funds amongst their clients.
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Perhaps not surprisingly given the sheer quantum of capital these institutional players are looking to invest, larger fund managers tend to have been more successful than medium or smaller fund managers in attracting capital from institutional investors. “The average pension fund manager absolutely loves hedge fund managers that perform and there have always been people who are spectacular performers,” noted the founder of one UK-based fund manager.
Our survey demonstrates that a shift towards a larger focus on institutional investors is now underway. Indeed, most managers responding to our survey told us that – by 2020 – pension funds (both corporate and public) would be their primary sources of capital. Slightly less than a quarter of respondents said that they expected corporate pension funds and public pension funds (23% and 21% respectively) to be their primary source of capital in five years’ time, while only 13% pointed to high-net-worth investors, and just 10% pointed to family offices as their primary source of capital in the future.
“Part of what we are seeing here is the result of continued pressure on the fund of funds approach as a point of entry for pension and institutional investors,” suggested the founder of one large North American fund manager. “As a result, we’re seeing more pension funds move towards direct investing, where they can have more control over their investments.”
Our survey suggests that medium-sized fund managers are the most optimistic about their ability to attract institutional investors in the future. More than half (54%) of all fund managers with AUMs of between $500 million and $1 billion said that they expect corporate pension funds to be their primary source of capital by 2020 (versus just 23% of their larger competitors).
As managers attract greater allocations from institutional investors, transparency is becoming increasingly important – and increasingly time-consuming. “Investors — particularly institutional investors — are demanding more detailed reports from their fund managers, arguing that they should have access to the same level of granular data that regulators enjoy,” pointed out the general counsel of one multi-strategy fund manager based in Hong Kong. “For smaller houses, this will likely mean adding dedicated resources just to manage the increased demand for reporting.”
Perhaps recognising this, most small firms seem pleased to focus on filling the gap as their larger peers shift to institutional investors. Smaller funds were twice as likely to say that high-net-worth investors and family offices would be their primary source of capital in the future versus pension funds of any type. But many smaller fund managers continue to attract some institutional capital.
“I don’t think small fund managers are locked out of the institutional side necessarily,” noted the COO of one large Hong Kong-based fund manager. “Big investors will continue to invest with the top small fund managers to diversify their risk. The challenge is in showing you are committed to best practices, have a strong track record, the right mind-set and an ability to diversify risk and allocate money wisely.”
Almost two-thirds of managers said that — over the next five years — they expect that the demographics of their clients will change to become much more diverse; only 20% said that their client demographics would likely remain the same.
“There’s still enough smart capital out there tosupport the growth of the industry, and recent reports suggest that capital flow allocations have increased to small and medium-sized fund managers recently, so I wouldn’t suggest that the market is skewed towards larger players at this point,” argued a North American manager.
NEW MARKETS COME INTO FOCUS
As the majority of fund managers start to plan for a change in investor demographics over the next five years, a growing number are also starting to explore new markets for growth. Our survey suggests that — increasingly — managers are looking to the emerging and frontier markets as their next big investment opportunity.
This year’s survey suggests that fund managers are standing on the cusp of a major shift in focus from west to east as new investors emerge and new markets come into view. Today, most capital invested in hedge funds still comes from North America and Europe. North America accounts for around 43% of investors, followed by Europe (excluding the UK and Switzerland) who make up 17% of investor capital, the UK (13%), Asia-Pacific (also 13%) and Switzerland (9%). Brazil, Russia, India and China (BRIC), emerging and frontier markets account for just 5% of investors.
However, the data suggest that some of the greatest inflow increases in pure percentage terms over the past two years have come from developing and emerging markets. 44% of those with investors in Asia-Pacific say they have seen an increase in investor activity from this region, while 17% cited a decrease; 41% of those with investors in the Middle East and Africa (albeit only a small number) say that they have seen activity increase (versus just 9% who said it decreased).
“We’ve seen a lot of growth in the Middle East with sovereign wealth funds and, today, they are right up there with US pension funds as our biggest allocation areas,” said a large US-based asset manager. “We definitely see a huge opportunity in China and expect increased asset flows from East Asia within the next five to 10 years.”
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In comparison, respondents seem to indicate that growth in the developed market is flattening. So while 37% said they had seen activity in Europe increase, 26% said it had decreased. Those with investors in Switzerland and the UK were almost just as likely to say that activity in those markets had increased as they were to say it had decreased.
Likely as a result of the shift in investor demographics and markets, the majority of managers say that — if they were to set up a new fund in the next five years — they would most likely domicile their master fund offshore. Not surprisingly, the Cayman Islands seemed the most likely destination, with 63% of managers identifying that country. Other domiciles identified by managers included the US (12%), Ireland (11%), Luxembourg (8%), Switzerland (3%) and Malta (3%).
Our survey suggests that managers are increasingly looking to the developed and emerging markets not just for new investors but also as a destination for investment capital. “In my opinion, managers should be placing about a quarter of their investment portfolio into the emerging markets,” argued a manager for a US-based fund manager focused on the emerging markets. “That is what people should do, but people usually don’t do what they ‘should’ do.”
More than four in 10 (43%) said they expect to change the markets in which they invest their capital. But interestingly, only 21% said they would invest more into developed markets, while 30% pointed to the emerging markets and 7% said frontier markets. Perhaps not surprisingly, those with existing offices in Asia-Pacific indicated a higher focus on the emerging and frontier markets.
“Our China strategy is more of a 10 to 20-year strategy; it may be somewhat irrelevant now except as a distribution channel, but down the road it will be increasingly important,” added the manager of one global fund manager based in the UK. “We’re absolutely looking at the frontier markets, particularly Africa, for future growth.”
CHANGING THE PRODUCT MIX
While our survey finds that managers are seeing an increased demand for customised products – such as funds of one and managed accounts – there are indications that ‘liquid alternatives’ such as UCITS and ‘40 Act funds are continuing to gain traction.
Throughout this survey, respondents have indicated that they are moving towards greater customisation of fund structures and fee arrangements; our data suggest they are also customising their product offerings. The trend towards customised product offerings is clear. Almost half (47%) of all fund managers report that they already offer a fund of one or managed account solution. 21% say they plan to offer these solutions within the next five years.
“When I talk to my marketing folks, they see fund of one and customised products as the big growth area,” said one large US-based investment advisor. “We’re still pushing our commingled products, but it’s become a much harder sell recently.”
Not surprisingly, large-sized fund managers were more than twice as likely as their smaller counterparts to say they already offered funds of one. But smaller fund managers seem keen to catch up: 50% of respondents from smaller funds said they plan to offer a fund of one solution in the next five years (half of those say they will offer the product within the next 12 months).
As we reported in our previous Global Hedge Fund Survey, liquid alternative funds such as UCITS and ‘40 Act funds are continuing to gain traction. As one manager of an offshore fund candidly noted, “Investors are definitely looking for more liquid products with shorter redemption notice periods – investors want to have their cake and eat it too.”
Indeed, 38% of respondents said that they either had, or were developing, a UCITS fund (making it the second most popular product offering according to our survey). More than a quarter (27%) said the same about ‘40 Act funds (the fourth ranked product).
“It’s become a matter of ‘why not’ as opposed to ‘why’”, noted one London-based fund manager who is currently launching their first UCITS fund. “Launching a UCITS fund aligns nicely with our strategy of liquid macro fixed income, but I also believe that the UCITS platform will be more attractive to European pension funds and investors that don’t want to put their money into a Cayman fund.”
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Fund managers headquartered in Europe were, as would be expected, most likely to say they either had, or were developing, a UCITS fund, while North American managers were most likely to point to an existing or planned ‘40 Act fund. Interestingly, however, fund managers headquartered in Europe demonstrated a high preference for both UCITS and ‘40 Act funds. Many managers also suggest that they are waiting to see how existing products in the market perform. “Banks and larger asset managers will eventually be all over liquid alternatives, but not until they’ve had time to prove their performance,” added a Canadian-based investment manager.
Some, however, suggest that the shift towards attracting institutional investors may dampen the appeal of launching new liquid alternative products for larger managers. “We want allocations from pension funds with longer-term strategies, so we have no interest in providing daily liquidity products,” said a UK-based manager.
Others worry about the longer-term impact of moving towards more liquid alternative strategies. “With UCITS funds and alternative investment funds (AIFs) there are differing approaches to the business that are being adopted in light of new and altering compliance requirements,” noted one UK-based manager. “The downside to this is that some marketplaces are being missed.”
Likely as a measure to retain control during a time of transition, the majority of managers (58%) said they would expect to use more direct methods when launching new products and funds into the market. Around a quarter (22%) said they would likely launch new funds on top of their existing funds business.
However, one in five respondents from smaller-sized fund managers said they would likely use platforms to launch new products, presumably in order to reduce operating costs and complexity. “Smaller managers are joining our platform because we take away the headache of operating infrastructure, which means our managers can just focus on trading — it’s what they like and what they’re good at,” added one large European hedge fund manager and platform provider.