An evolving hedge fund industry looks for new investors in a changing landscape Hedge fund
Contents What hedge funds need to know to stay ahead of the curve 3 Demographics drive new opportunities 4 Fees, costs, returns and competition 6 Changing models and more 8 International opportunities and challenges 10 Tax reform 12 Adapt and thrive 13
What hedge funds need to know to stay ahead of the curve Changing investor demographics, pressure to boost investment results while also cutting fees, increased competition and the ramifications of potential tax reform will drive significant changes in the hedge fund industry over the next few years. Following are overviews of several key trends that will present new opportunities and new challenges in the future. Success for any hedge fund starts by growing assets under management (AUM), and that means finding new investors. Traditionally, funds focused on institutional investors and a small pool of high net worth households. The recent explosion in households with a net worth of more than $5 million, however, provides a large new pool of potential investment capital, but also raises new challenges. This significant increase in investment capital available from individual investors provides opportunity for hedge funds focused on the individual market and for funds looking to diversify beyond institutional investors, says Michael Patanella, Audit partner and national leader of Grant Thornton s Asset Management practice, but it also raises new marketing, operational and regulatory challenges. This significant increase in investment capital available from individual investors provides opportunity for hedge funds. Michael Patanella, national leader of Grant Thornton s Asset Management practice An evolving hedge fund industry looks for new investors in a changing landscape 3
Demographics drive new opportunities According to Federal Reserve estimates, more than 10% of U.S. households now have a net worth in excess of $1 million, and that number is growing rapidly. Between 2014 and 2016, more than 800,000 U.S. households crossed the $1 million threshold. The average wealth of the top 5% of U.S. households is now nearly $2.4 million, up more than $400,000 in the last three years, and the top 1% now average about $10.4 million. The international market as well has a growing high net worth population. Not only is the pool of qualified high net worth investors expanding rapidly, it is also getting younger as millennials inherit wealth from baby boomers and grow their own assets. Funds targeting these new investors must deal with new preferences. 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. Tech-savvy millennial investors are more open to investments in new areas like Bitcoin or other cryptocurrency funds, a handful of which have seen spectacular returns recently. Growth 2020: The Changing Chemistry Between Hedge Funds and Investors, a study published in 2016 by FIS, finds millennials also demonstrating a preference for liquid alternative/40 Act funds and Undertakings for the Collective Investment of Transferable Securities (UCITS) funds. This type of shifting in allocation has led to overall consolidation in the asset management industry to accomplish investment options including private equity. Millennials and other investors are also looking for options that provide greater liquidity, such as exchange traded funds. As funds shift more of their focus from institutional to individual investors, they also must re-evaluate their offerings to better match market preferences. 4 An evolving hedge fund industry looks for new investors in a changing landscape
Shifting more attention to individual investors also means preparing for heightened regulatory scrutiny. The SEC has increasingly targeted hedge funds for more regular and intense examinations on a host of issues, including valuations, expense and trade allocations, and conflicts between managed and comingled funds. Hedge funds shifting toward individual investors will face increased regulatory scrutiny, particularly around marketing claims, conflicts and fees, says Steven Goldberg, director, Grant Thornton s Business Risk Services. One of the SEC s key areas of focus is ensuring effective protection of individual investors. A growing pool of high net worth investors means new opportunities for hedge funds 10% of U.S. households now have a net worth greater than $1 million Millennials inheriting wealth and growing their own assets represent a new investor market Top 5% of U.S. households average wealth is now nearly $2.4 million Even faster growth is in high net worth investors overseas, especially in China An evolving hedge fund industry looks for new investors in a changing landscape 5
Fees, costs, returns and competition All investors, individual and institutional, are pressing funds to show better results at lower fees, which is requiring fund managers to achieve better returns, explore new fee options and control expenses. After a few years of negative financial press, some leading hedge funds have rebounded with very strong years in 2017. A recent CNBC report highlights a number of funds that have reported gains of 20% or better for the year to date. Using artificial intelligence (AI) to drive investment decisions is an emerging strategy. A challenge when implementing AI is to move slowly and carefully and maintain human oversight for unexpected issues. The move toward AI is driven by two factors: the exponential growth of data available to make better investment decisions and the computing power available to process that data. Consider two facts. Some 90% of the data ever created was generated in the last two years (Media Post, IBM Marketing Cloud, Science Daily, among other sources). Meanwhile the cost of storing that data has dropped from $300,000 per gigabyte in 1981 to 10 cents per gigabyte today. The volume of data is such that exploring all of it for opportunities is beyond human capability, so some funds are considering AI options. While early returns do not show AI-driven funds outperforming other funds, AI is an emerging trend hedge fund managers need to watch. While funds may not choose to use AI to perform trades, leveraging AI as a research option can better enable funds to direct investments. 6 An evolving hedge fund industry looks for new investors in a changing landscape
Volatility funds are another option more hedge fund managers are considering. Volatility funds provide a hedge against losses when volatility arises, and a number of uncertainties cloud the horizon. What will ongoing political investigations bring, and how will those events impact the markets? Will geopolitical tensions escalate? How will the GOP s tax reform efforts affect the markets? Passive investment options, such as robo-advisers that allow investors to play a more active role in managing their accounts, can leverage technology to help attract millennial investors and, in the long run, may help control fund costs. These options will, however, require upfront investments in technology. While these options may deliver good performance under current market conditions, they may not do as well should volatility increase -- something funds will need to keep in mind given heightened investor sensitivity about results. Trends, fees, regulatory concerns Explosion of data and increase in computing power driving exploration of AI-driven investments and research Funds looking at robo-advisers and other passive investment tools to control costs, address millennial preferences 2 and 20 fee model giving way to new options SEC tightening focus on hedge funds AML/BSA concerns will drive new costs An evolving hedge fund industry looks for new investors in a changing landscape 7
Changing models and more On the fee side, the traditional 2 and 20 model is no longer a given. The Teacher Retirement System of Texas and other institutional investors are increasingly pushing a 1 or 30 model (see HFMWEEK, 1 or 30 fee structure on the cards for Texas Teacher RS, among other sources), where fees amount to either 1% of AUM or 30% of investment return, whichever is greater. The 1 or 30 model rewards funds when investment results are positive but protects investors in down years. As institutional investors drive lower or more flexible fee arrangements, individual investors will expect similar treatment. Funds should be prepared, and also need to implement the back-office changes necessary to calculate new fee arrangements. With funds under pressure on both the performance and fee fronts, efficiency takes on added importance. Funds are exploring automation and outsourcing options to hold down back-office costs. As they do, controlling cybersecurity and third-party risks takes on added importance. As funds adjust to millennial preferences for more interactive online account management options, cybersecurity risks will also increase. An effective cybersecurity program realizes that penetration of some kind is always possible and has plans in place to limit the damage from a successful attack and to quickly and clearly communicate with all affected parties. Steven Goldberg, director, Grant Thornton s Business Risk Services 8 An evolving hedge fund industry looks for new investors in a changing landscape
And the SEC and other regulators are ramping up attention to funds control environments. Funds should act now to ensure that third-party, cybersecurity and other key controls meet today s challenges. Cybersecurity doesn t mean just trying to prevent an attack, says Goldberg. An effective cybersecurity program realizes that penetration of some kind is always possible and has plans in place to limit the damage from a successful attack and to quickly and clearly communicate with all affected parties. If you look at recent high-profile cyber incidents, much of the reputational damage suffered has as much to do with a company s response to the attack as it has to the attack itself. Other regulatory costs will continue to increase as well. In particular, hedge funds may soon face new anti-money laundering and Bank Secrecy Act (AML/BSA) compliance rules, particularly know-your-customer requirements. The biggest challenge? Performing adequate due diligence to confirm beneficial ownership of invested funds, particularly funds from overseas. As the AML/BSA rules proposed for investment advisers will be consistent with those of banks and broker dealers, hedge funds can learn valuable lessons from those financial institutions, which usually have highly automated AML/BSA functions to both improve compliance performance and hold down compliance costs. Possible good news for hedge funds? Regulatory scrutiny may be relaxing under the Trump administration. A recent Wall Street Journal article quotes research from Georgetown University law professor Urska Velikonja that finds that both the cumulative amount of penalties ordered and the number of enforcement actions undertaken by the SEC have fallen over the past year, by 15.5% and 17%, respectively. Finally, heightened competition, increased pressure concerning both performance and fees, and the ongoing need for higher investment, particularly in technology, is driving consolidation in the industry. Funds are advised to realistically consider their current position and future strategy in light of that possibility and develop exit strategies if appropriate. An evolving hedge fund industry looks for new investors in a changing landscape 9
International opportunities and challenges Funds that choose to outsource often work with providers in India or other international locations to help control costs. But outsourcing is only one international issue. Consider the ramifications of Brexit for funds with European operations. London has long been the location of choice for funds with European market operations, but many are now considering new options to avoid being outside the EU, with Ireland and Frankfort heading the list. Brexit isn t the only consideration for hedge funds as far as Europe is concerned. Emmanuel Marcon s election in France and Angela Merkel s substantial re-election in Germany have tamped down uncertainty concerning ultranationalist movements. After years of recession and sovereign liquidity crises, things may be looking up for European equities, and for international equities in general. After a strong run dating back to 2011, the dollar is finally weakening against many foreign currencies, taking some pressure off commodity prices and boosting the outlook for some emerging markets. Gross domestic products (GDPs) are improving in the EU and Japan. After years of stagnation, the Bank of Japan projects an increase in GDP from 1% to 1.4% in 2017 and 1.5% in 2018. GDPs in the EU are up, with GDP growth in the Eurozone keeping pace with the U.S. for the first time since the financial crisis began in 2008. (See Financial Times, "Eurozone GDP revised," among other sources.) Valuations of U.S. stocks are high compared with international equities. U.S. price-earnings ratios are above historical averages while those for international stocks are below them. U.S. equities have outperformed foreign offerings for more than 90 straight months the longest streak in at least 50 years. With U.S. stocks appearing fully valued and market conditions improving in much of the rest of the world, conditions may be right for a strong run by foreign stocks. 10 An evolving hedge fund industry looks for new investors in a changing landscape
International opportunities on the rise Brexit driving relocation of financial operations out of UK Weakening dollar, improving foreign GDPs may signal stronger performance for foreign equities As funds target new investors, they also need to look overseas. While qualified millennial investors may represent the most rapidly growing domestic opportunity, China and other markets in Asia are generating new high net worth households at an even faster pace. For example, the fifth China Private Wealth Report, developed by Bain & Company along with China Merchants Bank, shows a six-fold increase in private wealth in China since 2006. Now, more than 1.6 million Chinese have investable wealth of at least $1.5 million. In total, high net worth individuals in China hold about $7 trillion in investable assets. U.S. equity valuations high compared with international options An evolving hedge fund industry looks for new investors in a changing landscape 11
Tax reform Some good news for hedge fund managers may be that the tax reform package initially proposed by GOP Senate leadership leaves the carried interest tax laws intact. Hedge funds will, however, want to consider other potential key changes: The corporate tax rate would be cut from 35% to 20%. This could make a corporate structure more attractive for some managers, especially if an initial public offering might be a viable exit strategy. So far, mark-to-market accounting for derivatives or a financial transactions tax are not part of tax reform. No state and local tax deductions (or significantly limited). Maybe managers will locate some of their functions to lower (or no) tax states. Of course, these are only proposed changes. It remains to be seen what form the final legislation will take when passed. The Democrats have voiced universal objection to the legislation, and even several Republican legislators have expressed reservations with the bill as currently drafted. Given that the current versions of the House and Senate bills on tax reform treat flow-through income differently and less favorably than corporate income, we are discussing with our clients potentially converting their management entities from partnerships into corporations says Layne Albert, Tax partner, Grant Thornton's Financial Services group. Whatever the outcome, businesses should get in touch with a professional to gauge the best outcome for their organization based on changes to current law and historic business operations. 12 An evolving hedge fund industry looks for new investors in a changing landscape
Adapt and thrive From new technologies to new investments to shifting investor demographics, hedge funds need to adapt to remain competitive in a rapidly evolving marketplace. Successful funds will be those that anticipate changing investor preferences, tailor investment strategies that meet those preferences with solid returns, and control costs and fees. An evolving hedge fund industry looks for new investors in a changing landscape 13
Contacts Michael Patanella Audit Partner & National Leader Asset Management practice T +1 212 624 5258 Steven Goldberg Director Business Risk Services T +1 212 624 5209 Layne Albert Tax Partner Financial Services T +1 212 624 5335 14 An evolving hedge fund industry looks for new investors in a changing landscape
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