If EY’s 2016 Global Hedge Fund and Investor Survey is anything to go by, hedge funds that lack scale will continue to find it challenging to operate in 2017.
1. Lack of scale
Smaller managers face great challenges to compete as they struggle to fulfill all their obligatory requirements with tighter budget constraints. On the other hand, greater fee income helps the funds with over $10 bn AUM in scale to maintain and continue to build out the operational, technological and regulatory infrastructure necessary to keep pace with industry demands. With a larger AUM, they also become more successful at attracting capital. It also allows these managers to innovate sufficiently to bring new products tailored to address investors’ desire for customization.
2. Insufficient differentiation
Hedge fund managers normally distinguish their investment strategies in a bid to differentiate their product offerings. To some extent, hedge fund managers have sought to differentiate by excelling over their peers within a particular sector or investment approach. Without demonstrating how their fund or approach compares against other alternative products that are vying for a share of the alternative portfolio, smaller hedge funds cannot attract sufficient AUM to remain competitve.
3. Pressure on revenue
Notwithstanding the lack of scale to draw in AUM, revenues are taking a hit in the changing fee structure. Investors who have turned to low cost, passive investment strategies, or those who reduced their use of external money managers are challenging the traditional 2-20 fee structure used by hedge fund managers, putting further downward pressures on revenue.
4. Increased costs
While outsourcing can keep costs down for a small hedge fund manager, outsourcing must be balanced against investors’ concern over the managers’ responsibility of those outsourced functions. And yet, investors demand that the cost of increased infrastructure should not be borne by them through higher fees.
5. Managing the supply chain
With the retreat of prime brokerage services, many managers have to fundamentally alter their brokerage relationships, entering into new ones and increasing the number of counterparties they transact with. With increased counterparties, come increased burden to monitor counterparties relationships effectively.
6. Fighting the talent war
Despite the looming threat of automated robo-advisors, “star” money managers continue to appeal and attract investors. Smaller to mid-sized setups need to incorporate long-term retention policies to retain talent, albeit an increasingly difficult task as venture capital and private equity sectors become more attractive of late.