How global hedge fund managers can embrace innovation

In our survey, investors noted they were more likely to decrease allocations to hedge funds in the next three years (15%) versus increase (11%). This is a slight change from our previous survey, when 13% of investors said they would decrease allocations versus 18% who would increase (most will keep them flat). There is a marked regional difference, with 25% of North American investors expecting to reduce allocations while 20% of investors elsewhere expect to increase.

There is significant investor demand for alternatives, with 40% of investors planning to shift hedge fund assets to alternative asset classes. Meanwhile, 20% of investors say they will begin using nontraditional hedge fund products for the first time.

Some of the more popular alternative asset classes where investors plan to allocate funds, or currently do, include private equity (76%), real assets (66%), long-only (53%) and best-idea products (49%). Despite investor demand, most hedge fund managers (except the largest) have slowed their investment in nontraditional product development.

Managers are looking to separately managed accounts (SMAs), customized products and nontraditional fee structures for growth. Over half of managers offer SMAs, and over half of investors say they invest in SMAs, with nearly half of their fund allocations residing in these accounts.

Investors using customized portfolio exposures doubled from 20% in our previous survey to 40% this time, and the number of managers offering these vehicles increased from 22% to 36%. Two-thirds of managers have adopted or are considering nontraditional fee structures to attract investors. Many investors (46%) said performance hurdles present more appealing fee structures, while 29% of managers said they are considering offering this structure to investors.

Thirty percent of investors said they would like to see hedge funds become more innovative within front office/investing. This suggests a distinct advantage for managers deploying these capabilities. Currently, 25% of managers have implemented something innovative into the front office to benefit the business.

On average, investors said only 24% of the hedge funds to which they allocate use nontraditional or next-gen data, but that percentage is expected to rise to 38% in a few years. Meanwhile hedge funds are looking to make tech investments in front-office systems/trading tools (27%), risk management tools and software (16%) and customer relationship management (14%).

In our previous survey, 48% of managers said they did not use or did not expect to use nontraditional data in their investment processes. Now 46% said they do. For 60% of managers, this means that they have a subset of their front-office team experimenting with the data. Some nontraditional data types currently used include social media data (27%), private company data (27%) and credit card data (25%).

Managers have historically responded to business challenges by adding headcount, which has been a main driver of margin pressure. Forty-four percent of managers noted an increase in headcount among their investment professionals, portfolio managers and research analysts. Similarly, 38% of managers said they saw an increase in expenses in these departments in the past few years. Managers looking to achieve scale should evaluate other solutions, such as investments in technology or outsourcing.

Investor pressure, especially on management fees, continues to force managers to lower operating expense ratios. A quarter of managers indicated they have, or expect, to reduce the management fee for their flagship fund. However, three-quarters of managers are holding steady. The average operating expense ratio is currently 1.75%, down from 1.95% in 2015.

Of hedge fund managers interviewed, 57% said their organization is investing, or will invest in, operational efficiency. In addition, 28% of investors said they would like to see their hedge funds become more innovative regarding their operational efficiency. Managers are specifically investing in technology in the middle and back office to improve speed and quality of data reporting and management.

Half of managers said their organization has implemented something innovative with their technology investments, while 40% said the same for automating manual processes. A quarter of managers, mostly those with over US$10b in assets under management have or will be making investments in artificial intelligence and robotics to strengthen their middle/back office.

Competition for the right talent is a major strategic issue facing hedge funds. This is true particularly in the front office, where over half of managers struggle to attract and retain executive investment professionals.

Smaller managers are not confident in their ability to fill critical leadership roles from within. Fifty-two percent of managers under US$5b said they need to hire from outside for almost all or many critical business leadership roles. Larger managers with more resources have implemented internal mentoring programs, cross-rotational assignments and external coaches to create seamless transition for filling leadership roles internally.

Investors view hedge funds’ future talent plans as a critical component in their decision to allocate. Talent is one of the greatest risks facing their hedge fund managers, according to 35% of investors. Fifty-eight percent of investors said that evaluating future investment professionals is an important consideration. Almost 50% of investors say that the future C-suite influences their investment decisions.

Managers are changing the talent profiles they seek and are taking steps to accommodate the workplace to employee preferences. More than 30% of managers said they have changed the profile of employees they seek for both the front office and back office. They are looking more for understanding of technology and data analysis.

Nearly 30% of managers said they view collaboration/collegiality as most attractive to prospective employees. Two-thirds of managers have adopted or are considering nontraditional fee structures to attract investors. Forty-five percent of managers have taken steps such as formally surveying or employing consultants to understand what employees are looking for in the workplace.