The hedge fund industry is in a constant state of flux as a result of government legislation, a changing client base, evolving business trends, globalization, and many other factors. These are only a few of the developments and trends that will shape the future of the industry.
Customized Fee Schedules and Other Favorable Terms for Investors Will Become Commonplace
Dissatisfaction with the performance of some hedge funds and news of several high-profile pension funds (including the California Public Employees’ Retirement System) exiting the sector have prompted many investors to reassess their holdings and request reduced and/or customized fee schedules. Traditionally, management fees have hovered around 2.0 percent, and average incentive fees were 20 percent. From 2015 to 2018, the use of the 2 percent (fund management fees)/20 percent (average incentive fees) model fell by 65 percent, according to a global survey by Credit Suisse Group AG. In the second quarter of 2022, average management fees were 1.36 percent, according to Hedge Funds Research. Incentive fees were 16.05 percent in the fourth quarter of 2021.
Some hedge fund managers—especially those at small hedge funds—are willingly customizing fees and products to attract funding from institutional investors, which have become significant providers of investment capital, and satisfy expectations from other customers. “Additionally, some hedge funds are at either extreme with their fee structures, with some charging no management fees, others charging extremely high fees, and some charging pass-through expenses instead of management fees,” according to Forbes. “This strategy allows expenses like rent, trading fees, technology, server costs, salaries, performance bonuses, and client entertainment expenses to be passed onto the investor.”
More Hedge Funds Will Close and Fewer Will Launch
There were about 17,378 hedge funds in the world in 2020, according to alternatives data provider Preqin. Given the simple law of averages, a significant percentage (especially small- and medium-sized funds) will shut their doors due to poor management and the lack of new investment capital or the withdrawal of funds due to investor dissatisfaction with lower rates of returns. “It has become increasingly difficult for managers of sub-$200 million in assets [hedge funds] to raise money, even if they have a very high-quality product, because most of the money has been flowing into hedge funds with the strongest brand and the most assets under management,” explained Don Steinbrugge, the founder of hedge fund marketing and research consultancy Agecroft Partners, in a BuzzFeed News story about the trend.
The number of new hedge funds being launched in the next five years is expected to slow. From Q4 2021 to Q3 2022, a total of 449 new hedge funds launched, according to Hedge Fund Research, down from 735 in 2017 and 1,040 in 2014. These figures are much lower than the peak of 2,073 funds created in 2005. Growing competition for investment capital and rising investor demand for transparency and cost/fee restructuring are causing some finance professionals to think twice about starting new funds.
The Client Base of Hedge Funds Continues to Change
The client base of the typical hedge fund has shifted significantly in recent years—prompting major changes in how funds raise capital, set pricing, and interact with investors, as well as in the types of strategies funds use to invest and the types of products that they offer. In 2001, contributions by institutional investors comprised only 5 percent of all capital at hedge funds. Contributions by institutional investors had skyrocketed to 58 percent of industry capital by 2017 (the latest year for which data is available). According to Evolving Demands on the Hedge Fund Administration Industry, a report issued by the technology consulting firm Capgemini, “the operational complexity of hedge funds has increased due to new demands from institutional investors such as frequent reporting, third-party proxy valuation, and an emphasis on internal controls, increased product complexity, and emerging regulations.”
While institutional investors remain a significant source of funding in the hedge fund industry, more individual investors are beginning to invest in hedge funds because of rising wealth. The Federal Reserve estimates that more than 10 percent of U.S. households now have a net worth in excess of $1 million. The average wealth of the top 2 percent of U.S. households is now almost $2.4 million. In the United States and Canada, high-net-worth individuals (HNWIs) had $83 trillion in assets at the end of 2022, according to Capgemini, up from nearly $21.7 trillion in 2019. A growing number of HNWIs are from the Millennial generation. “Funds targeting these new investors must deal with new preferences,” according to An Evolving Hedge Fund Industry Looks for New Investors in a Changing Landscape,” a report from Grant Thornton. “Millennials have grown up with interactive, online, real-time access to their financial data and expect the same transparency and level of service from their investment options. For hedge funds, that means new investments in technology, potentially including robo-advisers and other self-service options. It also means exploring new investment strategies and product offerings.” The emergence of more high-net-worth individuals could improve prospects for small- and medium-size hedge funds, which have had trouble competing with large firms for funding from institutional investors. But convincing these individuals to trust their money with small- and medium-sized firms has proven a challenge in recent years.
Hedge Funds Will Continue to Expand into Emerging Markets
Hedge funds in the United States, Canada, and Europe account for about 84 percent of all assets under management (AUM) worldwide, according to the Alternative Investment Management Association. Significant growth in investor activity is expected in the Asia/Pacific region and the Middle East. “The rise of Dubai as a hedge fund hub has been a notable industry trend since the global pandemic, as firms in traditional hubs like New York and London choose to open outposts in the emirate and other Middle Eastern locations,” according to Hedgeweek. Industry experts cite Dubai’s pro-business environment and favorable tax regime as two major factors fueling this trend. Well-known firms that have recently established a presence in the Middle East include King Street Capital Management, Balyasny Asset Management, Veriton Fund Management LLC, Hudson Bay Capital, and Asia Research and Capital Management Ltd.
Growing Focus on Environmental, Social, and Governance Issues
Another emerging area is environmental, social, and governance (ESG), which is an umbrella phrase used to discuss how a business or other organization interacts with society and the environment. ESG issues are becoming increasingly important to companies and other organizations due to investor pressure and other factors. They include climate change and wider sustainability; environmental compliance and liability management; diversity and inclusion; employee development and retention; customer welfare; community relations; and business ethics and governance, among others. “Hedge fund and private equity managers alike are responding to the increased pressure by developing corporate ESG policies,” according to the 2022 Global Alternative Fund Survey from EY. “Some 57 percent of firms have a governance structure, and 53 percent have embedded ESG into their investment decision-making.” According to the survey, the top ESG characteristics that hedge fund managers include in their investment decision-making process were governance (cited by 63 percent of respondents), climate risk (61 percent), human rights practices (41 percent), and diversity, equity, and inclusiveness (41 percent).
Regulatory Peaks and Valleys
The amount of regulation that is imposed on the hedge fund and other alternative investment sectors is greatly tied to the political party that controls Congress and holds the presidency. Although there are exceptions, the Democrats tend to favor increased regulation of the financial industry, while the Republicans believe that less regulation allows the business sector to prosper, which, they believe, ultimately benefits the average citizen. As a result, the degree of regulation swings back and forth when different parties control Congress and the presidency.
Financial scandals and the economic recession in the late-2000s prompted the federal government to take a closer look at the banking and financial assets managements industries. As a result, regulation of the hedge fund industry increased from the late 2000s to 2016. Here are some examples of recent legislation that affects the hedge fund industry:
- The Dodd-Frank Wall Street Reform and Consumer Protection Act requires all hedge fund advisers with more than $150 million in assets under management to register with the Securities and Exchange Commission and to hire a chief compliance officer to create and monitor a compliance program, among other rules.
- The Volcker Rule restricts banks from conducting certain investment activities with their own funds and prohibits them from investing in or sponsoring hedge funds; among other regulations.
During the Trump Administration (January 20, 2017–January 20, 2021) the Republican-led Congress and the administration reversed some of the provisions of Dodd-Frank and reduced regulation of the hedge fund industry. The tax reform bill passed by Congress in late 2017 left the carried interest tax provision intact (this provision fuels strong profits for hedge fund managers).
The Biden Administration (January 20, 2021– ) has increased regulation of the alternative investment industry. In 2023, the SEC adopted amendments to Form PF (the confidential reporting form for certain SEC-registered investment advisers to private funds). The amendments will require large hedge funds to file current reports regarding the occurrence of reporting events that could indicate significant stress at a fund or investor harm. The SEC says that the “reporting events for large hedge fund advisers include certain extraordinary investment losses, significant margin and default events, terminations or material restrictions of prime broker relationships, operations events, and events associated with withdrawals and redemptions.” It also says that the “amendments are designed to enhance the ability of the Financial Stability Oversight Council to assess systemic risk and to bolster the commission’s oversight of private fund advisers and its investor protection efforts.” In August 2023, the Securities and Exchange Commission also adopted new rules and rule amendments to the Investment Advisers Act of 1940 as a way to protect private fund investors and enhance the regulation of private fund advisers. The Alternative Investment Management Association and five other industry organizations filed a lawsuit against the SEC in response to these changes. More information on the new rules and rule amendments can be obtained at https://www.sec.gov/news/press-release/2023-155.
Finally, one law that’s expected to help hedge fund managers is the Jumpstart Our Business Startups Act (commonly known as the JOBS Act), which allows hedge funds to advertise and perform general solicitations, with the ultimate goal of reaching a larger number of investors. Despite the potential benefits of the act, many hedge fund managers remain skeptical. Reasons cited by fund managers for not engaging in marketing under the JOBS Act include concerns about additional costs involved with creating marketing campaigns and hiring marketing professionals, fear of increased scrutiny by the Securities and Exchange Commission, and a negative perception of marketing in general by potential customers. Over the long term, the law may be most useful to small and medium-sized hedge fund firms, which, historically, have had trouble competing for market share with large well-known hedge fund companies.
Growing Concerns About Cybersecurity
In recent years, high-profile data breaches have prompted financial firms to spend more of their budgets to ensure that data and intellectual property is protected from hackers, rogue states, and other cybercriminals. The U.S. Securities & Exchange Commission, as well as regulatory agencies in other countries, are also pressuring investment firms to institute better internal controls and implement other cybersecurity initiatives. Hedge fund managers surveyed by KPMG and the Alternative Investment Management Association (AIMA) in 2021 ranked “cybersecurity, including third parties” as the second most-important back and middle office investment area after “data management.” In addition, cybersecurity investment was the top priority (cited by 53 percent of respondents) of firms with less than $1 billion in assets under management. “Other constituents have moved cybersecurity concerns to the top of their agendas as well, according to the KPMG/AIMA survey. “Investor due diligence teams have added a series of inquiries about cyber threats and processes to curtail them. Regulators throughout the global community have routinely begun to define best practices and safeguards that hedge fund organizations should adhere to.”
Hedge fund managers have become more concerned with protecting their data after it leaves the control of their firm, for example, when it is handled by service providers and government regulators. Hedge fund managers cited “third parties” as the greatest risk of a cybersecurity threat, according to the 2019 Global Alternative Fund Survey from EY. Risk from internal infrastructure ranked second. Cyber breaches have occurred in recent years at the Federal Deposit Insurance Corporation, Department of Defense, Internal Revenue Service, the Federal Reserve, and other agencies. Look for cybersecurity efforts initiatives to continue to be strong in coming years.
The Rise of Cryptocurrencies
The financial Web site Motley Fool defines cryptocurrency as “an electronic cash system that doesn't rely on central banks or trusted third parties to verify transactions and create new units. Instead, it uses cryptography to confirm transactions on a publicly distributed ledger called the blockchain, enabling direct peer-to-peer payments.” The entire cryptocurrency market had a capitalization of $1.06 trillion in 2023, according to Statista.com, up from $237 billion in 2019. Bitcoin is the most popular type of cryptocurrency. On September 13, 2023, it accounted for 49.1 percent of the total cryptocurrency market cap, according to Slickcharts.com. Other cryptocurrencies with significant market capitalization include Ethereum (18.5 percent), Tether (7.98 percent), and BNB (3.14 percent).
Indexes have even been launched to track hedge funds that invest and trade in cryptocurrencies. In December 2017, Hedge Fund Research launched the HFR Blockchain Composite Index and the HFR Cryptocurrency Index to track hedge funds that invest and trade in cryptocurrencies. About 300 hedge funds are focused on cryptocurrency. Total assets under management of crypto hedge funds surveyed by PwC for its Annual Global Crypto Hedge Fund Report 2022 were $4.1 billion in 2021, up 8 percent from 2021. Traditional hedge funds are also investing in cryptocurrencies.
Although cryptocurrencies have seen jaw-dropping jumps in value, many hedge fund managers are skeptical about this new financial product because of questions about cybersecurity and potential government regulation, as well as shocking decline in values. Others worry that an artificially high market has been created to entice investors (studies show that most people buy cryptocurrency as an investment, not as a way to make purchases), with more hard crashes expected in the future.
“While the recent performance has been exciting, trading and investing in these evolving areas requires specialized expertise and involves substantial volatility and risks, both real and structural,” advised Kenneth Heinz, president of Hedge Fund Research, in a news release. Despite the risk, Heinz believes that bitcoin and other digital currencies “will continue to grow in an absolute sense and as a component of hedge fund exposures.”
The Growing Use of Alternative Data
More managers are using data analytics tools to collect and study alternative data to obtain investing, operational, or other benefits over their competitors. Alternative data, which is also known as next-generation data, is nontraditional and non-market economic and financial information, such as weather patterns, satellite imagery, business performance metrics, online reviews, consumer spending/lifestyle data (including payments data), and social media trends. Thirty-four percent of hedge fund industry professionals who were surveyed by the Alternative Investment Management Association, Simmons & Simmons LLP, and Seward & Kissel LLP during Q4 2020 said that their firms were investing in alternative data technologies (which was the most-cited type of technology by survey respondents). Overall, large firms with more than $1 billion of assets under management (AUM) were more likely (48 percent) to invest in alternative data technologies than firms with less than $1 billion in AUM (18 percent). More than 300 industry professionals (82 percent of whom were hedge fund managers), accounting for an estimated $1.3 trillion in assets under management (AUM) were interviewed to complete the survey. The results were published in Global Hedge Fund Benchmark Study: Beyond the Horizon.