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Financial Services Insights – August 2014 – Five Issues for Hedge Fund Managers to Follow

Aug 5, 2014

We are now through the 2nd quarter of 2014.  This article seeks to describe some of the key topics and trends that should be top-of-mind for hedge fund operators. The major themes in the industry focus on capital raising and regulation, topics which have been at the forefront since the financial crisis. There are, however, new developments in both areas, particularly in liquid alternatives and high frequency trading.  2014 is shaping up to be a major growth year with respect to total industry AUM and managers should look to be as appropriately positioned as possible.

1. Trends in Capital Flows

Always top-of-mind for managers is where capital is flowing within the industry. According to HFR, hedge fund industry assets reached $2.7T as of April 30, 2014. AUM growth can be attributed to both capital flows in 2013, estimated to be $63B of new capital into hedge funds, and positive overall performance, up 14.60% in 2013 (HFRI Equity Hedge Index). Equity long/short continues to be the most popular strategy for investors, but managers running low net or market neutral exposure receive a disproportionate amount of interest. This is no doubt due to the narrow range that markets have been trading in for most of the year. Other strategies such as credit long/short have seen declining focus from the investor community, as the FOMC-driven tight spreads have investors looking elsewhere for returns.

Why is it important?

Raising capital remains a common challenge for many hedge fund managers. The largest managers have been able to raise significant capital from the institutional investor community including pensions, endowments and sovereigns and these groups are therefore wielding more influence than ever on the objectives of the industry. Funds with greater than $1B in assets represent only 7.9% of the total number of managers yet control approximately 80% of industry assets. Smaller managers have had to offer new founder share classes to attract capital from allocators who have the ability to invest at an early stage. Given these dynamics, managers need to be more focused than ever on expending their limited time and money on marketing to the right investors at the right time.

2. Alternative Mutual Funds/Liquid Alternatives

We continue to see a convergence between hedge funds and mutual funds in 2014, as the broader liquid alternatives universe (e.g., UCITS, Long Only, Passive Index, and ETF funds) continues to represent a significant potential growth area for hedge fund managers. Some managers, who were already forced to register as investment advisors with the SEC, are developing alternative products which target retail investor capital and thereby bridging the gap between traditional asset management and alternatives. In addition, the financial crisis and subsequent regulatory initiatives have sparked increased investor demand for liquid alternatives which can provide non-correlated products within a regulated framework.

Why is it important?

This trend has potentially positive and negative ramifications for the hedge fund industry. On the positive side, these products are appealing to alternative investment managers as they represent a broader market opportunity and capital base outside of the traditional alternative investors. Mutual funds are liquid and easily investable by large and small investors alike.

On the negative side, mutual funds inherently carry lower fees than hedge funds, may increase the fee pressure already eroding the traditional 2/20 fee structure for hedge fund products, and have the potential to cannibalize existing offerings.

3. Impending Regulatory Changes on Bank Leverage

While not a new development, 2014 has brought clarity to a number of regulatory initiatives impacting the hedge fund industry. Following the financial crisis many global regulators and lawmakers have worked to craft regulations and rules to reduce systemic risk in the banking industry. The rules have focused on a more rigorous and quantitative approach to asset/liability management and a meaningful reduction in bank leverage. Various regulatory bodies and committees such as Basel III, Dodd Frank, CRD IV and other bodies have enacted or proposed rules that will have a significant impact on prime brokers and the way they interact with their clients. At a high level, the regulations (Basel III, US SLR, LCR, CRD IV) aim to reduce bank leverage while also creating greater liquidity. The goal is to avoid liquidity shocks like the ones felt during the 2008 financial crisis. As a result, increasing bank capitalization requirements will force institutions to consider which businesses they deem worthy enough for capital allocation.

Why is it important?

First off, by lowering aggregate leverage, the banks will have a more difficult time meeting the ROE targets set by their investor base. This will push the banks to allocate assets to higher ROE businesses and shrink the aggregate balance sheet that is allocated to prime brokerage. With a reduced balance sheet, prime brokers will need to be more efficient and selective in the types of business they finance by looking for clients that are natural compliments to their financing books. Additionally, prime brokers may force discussions around re-pricing of services and the quality of collateral they hold. Overall, banks need to increase capital, reduce liquidity risk and constrain bank leverage which will reduce bank profitability and increase costs. Finally, the focus on client profitability has changed from easy to understand net revenue to an ROA based calculation.  All these factors will impact managers’ relationships with their counterparties.

4. Controlling/Re-Allocating Costs/Outsourcing

Managers need to understand and plan strategically for the increasing cost of compliance and regulation.  The possibility of a near-term mandate for a chief compliance officer function for all hedge funds will further increase the cost of business for the already fee-constrained industry. Across the operational functions in the business (e.g., technology, finance, operations and compliance), managers need to seriously consider what to in-source, out-source and later-source.

Why is it important?

The largest managers may have the ability to absorb these additional costs without destroying their profitability, but emerging, small, and mid-sized managers may have a much harder time. Business planning, staffing, and technology build-outs are essential to stay current on industry changes. 

5. High-Frequency Trading

Whether or not managers agree with the polarizing condemnation of the high-frequency trading business spelled out by Michael Lewis in “Flash Boys,” it is undeniably one of the more widely talked about hedge fund stories of 2014. Lewis asserts that markets are rigged by the speed at which high-frequency trading firms are able to digest information and use it to gain a competitive advantage, thus directly raising the cost of trading for investors by beating their orders to the market place.

Why is it important?

Issues like the one raised by Lewis in “Flash Boys,” however sensationalized, erode investor confidence in markets and increase the propensity for additional regulatory scrutiny of hedge funds. The SEC has already announced (on May 2, 2014) a $4.5 million penalty against the NYSE for failures to follow rules regarding connectivity and market data dissemination. Listed in the release was a specific reference to co-locations, computer hosting locations that allow high frequency shops to gain a speed advantage by being in proximity to exchanges. 

One of the biggest business risks to managers today is the growing cost of regulation. Regulation has its benefits, provided that it works to increase investor confidence in the markets. When investor confidence increases, we have more participants and thus more liquidity, less volatility, better risk-adjusted returns and healthier markets overall.   It seems that every few years there is an issue (e.g., Madoff, Flash Crash and “Flash Boys”) that serves to shake confidence.  In the case of “Flash Boys,” the damage seems to be minimal, but it is an interesting view into the voracity with which people accept conspiracy surrounding financial markets.

Andrew Volz is a Director with Wells Fargo Prime Services. You can contact Andrew at 212.822.2004.

Financial Services Insights – August 2014

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