2016 Hedge Fund trends

Perspectives

2016 Hedge Fund trends: Taking a closer look

Interview with Ted Dougherty

Ted Dougherty, US Hedge Fund and Tax Investment Management leader, provides a view into expected trends and issues for the year ahead—including trends that may disrupt business as usual.

What are the top three issues for the hedge fund sector in the coming year?

Well, performance has to be at the top of the list. It’s always at the top of the list! With good reason, of course. That said, this is particularly important as hedge fund leaders try to dig out from under problems resulting from the devaluation in China.

The global regulatory environment is also a big one for 2016. It’s common knowledge at this point that the regulatory environment in the US has gotten more challenging. But hedge fund leaders seeking to go global – and there are many of them – are having to deal with a patchwork of regulatory standards. And it’s not just from the expected, traditional sources such as the UK’s Financial Services Authority, for example. Tax authorities are also keeping things interesting, to say the least.

There’s also the issue of achieving size and scale – particularly in the middle tier of hedge funds, and to some extent in the lower tier. These firms need to be able to offer multiple products to investors in order to grow, which requires what is sometimes referred to as “permanent capital.” We’ve already seen a lot of creative ways employed for doing that – for example, some fund managers are selling a stake of their business in order to get immediate access to the capital they need to grow. I think we’ll see more creativity, and wider adoption of some of the newer techniques already being used to scale up.

Key takeaway:

Performance will be important as Hedge Fund leaders try to dig out from problems resulting from devaluation in China.

Where do you see opportunities for growth and innovation?

Pension plans may be a strong source of growth for hedge funds going forward. To date, there’s a sense that they’ve only dipped their toes in the water of hedge funds, but that is expected to change. Not only is there a lot of interest in pension funds within the hedge fund industry, many pension funds are deep in a hole investment-wise. They’re going to have to consider new types of investments in order to dig out – and hedge funds are a strong option.

We’re also seeing an acceleration of hedge funds moving into the direct lending business. As banks have pulled back on lending in the wake of the financial crisis, hedge funds sense opportunity. In the past, many hedge funds basically dabbled in lending – it operated at the edge of their business. Today, many hedge funds are launching as direct lenders.

Key takeaway:

Pension plans may be a strong source of growth for Hedge Funds going forward.

What trends might disrupt “business as usual” in 2016?

This industry is built on disruption – and there’s truly no telling what types of disruption we’re in store for as we move into 2016. This year it was China and spillover from the fall in energy prices that started in late 2015. Next year it could be any number of potential geopolitical disruptions – Syria, Russia, you name it. Or it could come from the energy space again. Or somewhere else entirely.

Many would likely say that regulation is likely to be a major disruptor in 2016, but you know, there’s always a lot going on in the regulatory space. I don’t know that any of it is likely to qualify as a major disruptor – this industry tends to absorb those types of changes and move on.

Key takeaway:

Geopolitical issues may disrupt business as usual in 2016 for the Hedge Fund industry.

What are some steps companies can take to address these challenges?

I think there’s still a lot of room for hedge funds to more fully examine the impact of potential market events on their portfolios, and on their risk profiles. Stress testing is certainly not a new concept in the world of hedge funds, of course. But hedge fund leaders could be conducting much more thorough stress tests, by and large, than they are today. They might even find that some hedges don’t operate in the way that they thought they would. Because stress testing requires a good amount of resources, the larger hedge funds have more robust capabilities in this area. I think we’ll see more stress testing throughout the food chain, however–and that would be a positive development. We may see more robust vendor-based option emerging for the mid-size and smaller-sized firms that do not have this capability in-house.

Separately, we all know that more regulation is on the way–and the industry should work to anticipate regulatory changes. When this inevitably happened in the capital markets space, we saw a lot of mistakes being made. The hedge fund industry can learn a lot from the capital markets–and now is the time to pay attention.

There are also reasonable, common-sense ways to avoid regulatory entanglement. For example, many hedge funds get a lot of questions about what expenses are charged to the fund, versus those that are charged to the management company. Rather than wait for regulators to spell it all out, err on the side of fairness and reasonableness. Charge less to the fund than may be reasonable–and avoid the risk of being called out. Alternatively, in the spirit of fairness and reasonableness, amend the fund documents to make the expense allocation process more transparent to investor.
 

Key takeaway:

The importance of stress testing will continue to grow in 2016 – particularly for smaller Hedge Funds.

What long-term disruptors could reshape the industry?

It is difficult to predict with any certainty which disruptors could change the hedge fund industry down the line. That said, I think many of the trends we’re already seeing are going to ultimately be disruptive. A changing competitive landscape could reshape the industry. It’s easy to imagine a future in which smaller players are pushed out altogether, medium players are either bought out or pushed out, and what’s left is a relatively small number of massive hedge funds – those in the $50-100 billion range.

I also think costs could be disruptive, due to a fundamental tension. On one hand, costs will almost certainly increase for a lot of predictable reasons, starting with the costs of regulatory compliance. Meanwhile, clients may not be willing to pay higher fees. How this tension is resolved may have big implications for the industry.

Key takeaway:

A changing competitive landscape could reshape the Hedge Fund industry over the long-term.

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