The impact of digital transformation and global regulatory changes on fund of funds strategies

The Fund of Funds (FoFs) sector is a pillar of the global alternative investment ecosystem, as it offers investors diversified exposure to a rich spectrum of asset classes, including private equity, hedge funds, and real estate. This article explores how the FoFs sector is being reshaped by two powerful forces: the rapid pace of digital transformation and the complexities of a shifting global regulatory environment.

Luxembourg stands out once again as a global hub with total net assets under management in investment funds equaling approximately EUR 5.4 trillion as at April 2024,¹  and displaying a yearly increase of over 5% from 2022 to 2023.²  Supported by a robust regulatory framework, political and economic stability, and an efficient tax regime, Luxembourg is a magnet for FoFs seeking a favorable operating environment.

As per ALFI’s Annual Report,  in December 2023,³ Luxembourg's UCI landscape (UCITs, PART II, SIFs, etc.) totaled 13,981 fund units, reflecting the depth of the industry, with FoFs representing a significant share (14%). The FoF sector demonstrated remarkable strength, totaling net assets of nearly EUR 352 billion, about 7% of the total net assets of Luxembourg UCIs for the same period. 

Strongly influenced by the regulatory environment, investor appetite, and the fund's objectives, FoFs in Luxembourg typically adopt structures like SICAV and Specialized Investment Funds (SIF). Within SIFs only, FoFs turned out to be the largest investment policy by far, both in terms of fund units (34% - 1,076 units), and in terms of net assets (23% - EUR 173.5 billion) underlining a strong 12% increase in net assets compared to 2022, and a pivotal role in Luxembourg’s investment landscape.

By providing diversified investment options, FoFs have demonstrated strong resilience and growth potential. As a matter of fact, FoFs were one of the very few asset classes to report close to break-even net inflows last year, alongside bonds, thereby highlighting a challenging year for fund flows. The only positive inflows were evidenced within private equity and money market / short-term instruments, while most of the other asset classes, such as equities, balanced assets or real estate, recorded significantly more redemptions than subscriptions, partially driven by the impact of financial markets.

As FoFs continue to evolve, they are increasingly impacted by the dual forces of digital transformation and a complex, ever-changing global regulatory environment. These dynamics are reshaping operational and strategic frameworks, demanding a reevaluation of traditional approaches to fund management and compliance. 

Marked by its complexity, the regulatory landscape presents challenges, such as jurisdictional variations while adapting to international standards like FATCA, CRS, and guidelines set by entities like the Financial Action Task Force (FATF). The latest regulatory changes in Europe impacting FoFs are the amendments to the AIFMD, or AIFMD II, which made significant progress in its legislative process. The final text of the political agreement on AIFMD II was approved by the European Parliament and the Council in February 2024. The Directive's provisions were published in the Official Journal on 26 March, and entered into force 20 days later, on 15 April. The 24-month countdown from entry into force to transposing the changes into national law then began for EU Member States, as the new provisions will become effective on 16 April 2026. 

In addition, the regulatory landscape for FoFs is also impacted by rigorous AML and CTF standards, demanding tax compliance, reporting, disclosures, and transparency requirements. These intricacies that FoFs must manage are further complicated by the emphasis put on detailed investment strategy reporting, the integration of ESG factors into investment decisions, the impact of Brexit on cross-border operations, along with the need to stay informed on regulations. The capacity of FoFs to navigate these changes effectively is becoming a defining factor in their ability to achieve success and offer substantial value to investors in the competitive alternative investment space.

Digital transformation within the FoFs sector is not just a trend: it is a strategic imperative. From the enhancement of traditional processes to the reshaping of investment management, digitalization is about leveraging innovation to stay ahead. The milestone of this digital shift lies in advanced analytics, big data capabilities, machine learning, and AI to a certain extent. Not only do they empower FoFs with regard to sharper investment decisions, deeper target analyses and patterns identification, but they also bring investor reporting to unmatched levels of customization and clarity.  A few sector-focused software providers have, for instance, leveraged advanced analytics capabilities to provide enhanced solutions that redefine the fund administration function for FoFs within the private equity and real estate sector. The deployment of investor portals and mobile applications also provides stakeholders with real-time access to critical fund performance data and document repositories. This level of accessibility and transparency does not only strengthen investor trust, it also elevates fund value proposition in this highly competitive market.

These digital tools enable funds to redefine efficiency and compliance in the increasingly complex and competitive landscape of alternative investments. As FoFs are confronted with global regulatory changes, their operational frameworks and investment strategies are significantly influenced. This regulatory landscape is marked by constant movement, as we previously mentioned, with the AIFMD amendments in Europe which aim to enhance transparency and protect investors. Similarly, the implementation of FATCA and CRS on a global scale aimed at fighting tax evasion requires funds to report information on their foreign investors.

As regulations become more complex, digital tools offer the agility needed for FoFs to adapt swiftly. Among the regulatory technologies (RegTech), a few service providers have designed their platforms to transform how organizations manage their compliance obligations. Leveraging AI and machine learning, they can offer real-time financial crime risk detection and compliance solutions, significantly reducing the risk of non-compliance, tracking investor eligibility, and even ensuring adherence to AML regulations. On another note, some vendors offer comprehensive blockchain analysis tools, which are extremely important in detecting and preventing illegal activities related to cryptocurrency transactions and crypto-related matters. Such platforms are particularly relevant for FoFs that are exploring or already involved in crypto-related investments, offering critical insights and tools for compliance with AML and CTF regulations.

To provide another concrete application example, tailored regulatory reporting solutions facilitate accurate and timely submissions to regulatory authorities by collecting data from various sources to automate the generation of complex reports while meeting the specific formatting and content requirements of different regulatory bodies. Not only does it help to streamline the reporting process, but it also minimizes the operational risk of manual errors. In addition, cross-border data sharing technologies are proving themselves as extremely valuable for FoFs operating in multiple jurisdictions. They ensure that data related to investments, investors, and transactions can be easily shared and accessed across borders, in compliance with local regulations. 

The journey forward for FoFs therefore appears as closely tied to the strategic adoption of technology, where innovation is not only a tool but more importantly a foundation for future growth and resilience. The integration of technology across operations – investor relations, portfolio management, fund administration and compliance – becomes essential. This comprehensive digital strategy must navigate the complex regulatory landscape with agility and foresight, leveraging RegTech solutions to anticipate regulatory shifts, partially automate compliance processes, and ensure seamless alignment with global standards. This forward planning will allow FoFs to stay ahead of regulatory curves, transforming compliance from an obstacle into a competitive edge.

Another strategic area for investment is in cybersecurity and data protection. As FoFs increasingly rely on digital technologies, the risk of cyber threats escalates. The implementation of robust cybersecurity frameworks coupled with ongoing staff training in the best practices of data protection will be key to securing sensitive investor information and maintaining investor confidence.

As we look to the future, it seems obvious that the path ahead for FoFs will be highly impacted by the technological advancements. The integration and leverage of technology offers more than just operational efficiencies. It presents a strategic and competitive advantage, enabling fund managers to focus on their core objective of delivering superior investment performance while maintaining robust compliance in a rapidly evolving investment landscape.

Embracing this digital future requires FoFs to be agile and forward-thinking. The role of leadership in driving digital transformation cannot be overstated. Fund managers and executives should lead by example, supporting a culture that embraces change and innovation. By doing so, they will not only secure their position in the alternative investment space but also pave the way for new growth, operational resilience, and enhanced investor satisfaction.