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The alternative investment industry outlook for Q2 2019 including U.S. tax code changes.

Q2 2019 – Alternative Investment Industry Outlook for Q2 2019 and Beyond

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2018 was a challenging year for hedge funds. Managers in this highly competitive industry are constantly seeking improvements to gain an advantage in identifying and capturing inefficiencies in the marketplace. The days of brand-name managers resting on the laurels of past performance are now going away. Many of these managers will need to reinvent themselves in the race for alpha.

Although the S&P 500 was up 9% for the nine months ended September 30, 2018, in the three months that followed, all gains in the market had all but vanished as the S&P 500 was down 14% in the fourth quarter and ended the year down 6.2%. Hedge funds with significant correlation to the equity markets, such as equity and event-driven strategies, saw significant declines as compared to funds with less correlation to the equity markets (i.e., fixed-income, relative value, and credit), which ended the year slightly positive or neutral. Managers with high equity beta -- a historical measure of volatility measuring how an asset moves versus a benchmark -- were hurt badly in the fourth quarter of 2018. As a result, the overall hedge fund industry saw returns of 4.5% (HFRI Weighted Index) with outflows of $35 billion leading to a decline in assets under management (AUM) of about 3% for 2018.

As investors continue to seek alpha -- a historical measure of an asset’s return on investment compared to the risk adjusted return -- within their portfolios, equity-long exposure funds will be under pressure. The allocation of funds appears to be towards fixed-income, credit and equity quant funds. Long/short hedge fund managers with exposure to overall market beta will continue to see outflows and those managers focused on large-cap stock may experience challenges in finding a market advantage. In the long/short space, the demand will be in sector specialized funds with the focus being in the healthcare and technology medium and small-cap markets. Asia focused funds should continue to see demand.

In addition, fee pressure will continue. Currently, on average, investors pay approximately 140 basis points in management fees and about 16% in performance fees. This is much different than the standard 2%/20%. Certain managers may want to consider reducing their fees, in an effort to retain current AUM until higher returns are achieved. Investors paying the highest fees are also expecting to receive the highest net return. And, because investors are increasingly trying to differentiate between alpha-driven and beta-driven performance, the use of hurdles for performance may become that much more important.

Investors historically have paid less attention to the overall expense ratio or which expenses the manager has charged to the fund. There is an expectation that there will be much more focus on this issue in light of recent changes to the U.S. tax code that limit the deductibility of fund expenses for taxable investors. As investors and their advisors begin to address 2018 taxes, they will realize the extent to which these expenses are affecting net returns. As a result, we may see a reduction in the expense allocations or an increase in the number of hedge fund managers being forced to apply a cap on fund expenses.

Our expectation is that the number of active hedge funds will either stabilize or shrink slightly over the next five years. This coincides with the fact that there has been a dramatic drop in new hedge fund managers entering the sector each year. How hedge fund managers adapt and evolve to meet the needs of a substantially different investor base will, more than likely, determine their success and longevity. Many may find themselves opening local offices to accommodate a more regionally dynamic investor pool, expand their range of product offerings, or invest in new technology and approaches. It is safe to say that the brand name hedge fund managers will have to reinvent themselves if they hope to stay in the game.


Engaging Alternatives - Q2 2019

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Garth Puchert, Audit Partner of EisnerAmper's Financial Services Group, is primarily devoted to private equity funds, registered investment companies, investment advisors, mutual funds, hedge funds and broker-dealers in securities.

Philip DeRosa CPA - Director in EisnerAmper's Audit and Assurance practice and a member of the Financial Services Group has nearly 20 years of experience in serving and advising clients in the investment management industry.