Insights on...
HEDGE FUNDS
A LOOK AHEAD: WHAT HEDGE FUNDS
SHOULD C ONSIDER HEADIN G INTO 2015
Northern Trust Hedge Fund Services executives share their outlook on trends facing the industry in 2015.
1. What are the biggest regulatory challenges you think the industry will need to
address in 2015?
Carl Lingenfelter, Chief Administration Officer, Northern Trust Hedge Fund Services:
I think the industry has managed to work out most of the basic reporting functions associated
with new requirements like AIFMD, CPO-PQR and AIFMD Annex IV. Some firms are outsourcing
that activity to administrators, others are managing it internally, but for the most part, those
functions are now well established and are approaching steady-state execution.
In 2015 however, the industry is going to have to start engaging with the operational and strategic
impact of derivatives regulation. Almost everyone agrees that central clearing and electronic
execution are good things in principle, but reality makes things much more complicated. For
starters, you have new requirements for repository reporting and portfolio reconciliation. But
the real hitch is that we’re in the middle of the transition, so if you trade a diverse array of assets,
you’re going to have some assets that are managed the “old” bi-lateral way, some that are centrally
cleared but still have paper-based execution, others that trade and clear on SEFs – and you need
operational models to support all of those. Managers need to think all of this through if they
don’t want operational limitations to get in the way of trading strategy.
Managers with global portfolios face another level of complexity. AIFMD, EMIR and numerous
FATCA-style regulations are talked about as “European” regulations. In reality, however, the actual
requirements often fall to individual governments, and so there is a lot of nuance and variance
that needs to be properly addressed. These regulations are in varied states of maturity, and while I
think we will eventually see regulators approach consensus, it’s tricky terrain at the moment, and
I expect it will remain that way for a while.
2.What do you think will be the industry’s most significant challenge in 2015?
Peter Sanchez, Chief Executive, Northern Trust Hedge Fund Services:
It’s been an eventful year, and I think there are a number of challenges on the horizon – Carl
just spoke to the ongoing operational challenges with regulation. Cyber security is another major
issue that’s only going to grow in importance over the next several years.
But the broadest and most crucial challenge in the immediate future, in my view, is the issue
of data management. Many of the other industry challenges – regulatory compliance, evolving
market operations, the growing popularity of various fund or managed account structures – tie
back to a managers’ ability to effectively maintain and make use of data. Managers need accurate
data to meet the needs of a diverse range of stakeholders – investors, management, front office
personnel, regulators and counterparties – and as these needs grow more complex, it’s straining
the abilities of older technologies.
This year there has been a lot of discussion about the technology demands on the modern hedge
fund, as well as discussions about alternatives to traditional operating models. In 2015, managers are
going to have to think critically about how they manage “big data,” and the most forward-thinking
managers are going to find ways of leveraging data and target operating models to support alpha
generation by giving their stakeholders faster access to more accurate information, thus enhancing
their ability to execute, manage and control their strategies. What we call Operational AlphaTM.
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3.Many have focused on the emergence of liquid alternatives as a major topic of conversation this year – what’s the prognosis for liquid alts?
Peter Cherecwich, President, Global Fund Services, Northern Trust:
We believe liquid alternatives will become a long-term and significant part of the alternatives
picture, but they are far more likely to expand the range of available alternative products than
they are to cannibalize traditional hedge fund distribution channels.
Liquid alternatives make a lot of sense in certain respects: they’re a means for managers to
establish new distribution channels that reach out to untapped pools of capital, while they give
retail investors access to the kind of noncorrelated returns and risk diversification that have
historically been unavailable to them.
But the very nature of registered products puts some pretty strict limitations around what
you can do from a strategy standpoint. While certain strategies like long/short equity or managed
futures can work within a registered product, traditional hedge funds will always have a place
because they generate value by taking large positions to gain influence, using leverage, investing
in less liquid products, and other tactics registered vehicles cannot do.
So we think liquid alternatives will grow in popularity, but we don’t see that growth as coming
at the expense of traditional hedge funds. Rather, we see them as complementary products that
have their own unique qualities and distinct target markets.
4.The ongoing battle between investors and managers over fees shows no sign of letting up. Do you think 2015 will see a major shift in the manager-investor dynamic, and if so, how?
Jeff F. Boyd, Chief Operating Officer, Northern Trust Hedge Fund Services:
In recent years, we’ve seen a slow move away from the 2 and 20 fee structure, with management
fees looking more like 1.5% and 17% on average. Realistically, a significant further decrease in
the level of manager compensation is unlikely. What we do expect to see, however, is continued
alterations to the terms of manager compensation.
In 2014, we saw a noticeable rise across our client base of the use of hurdle structures instead
of the traditional high water mark, including some quite creative series of hurdles mechanisms,
as well as underperformance hurdles – where the manager receives an incentive for preserving capital
better than the benchmark in a down market. We’ve also seen more negotiations around terms,
such as reductions in fees in exchange for longer lockups or longer redemption notifications.
I think the discussion has shifted from talking about absolutes – higher fees vs. lower – to a
negotiation of trade-offs and relative benefits. Can I lower my fees if I agree to sacrifice liquidity?
Can I defer payment until we’ve gotten past beta and into alpha generation? This leaves more room
for investors and managers to find compromises that balance managers’ desire for compensation with
investors’ need to feel that they are getting value commensurate with what they are paying.
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5.How should investors think about hedge fund investment and the hedge fund
industry as we look to the new year?
Carl Lingenfelter
Much of the discussion since the CalPERS announcement in September has been in the form
of a binary question: “Should investors allocate to hedge funds or not?” That presumes that hedge
funds are a monolithic “one size fits all” asset class, and we don’t think that’s true.
Savvy investors are not asking themselves whether they should invest in hedge funds, but how
should they invest. Manager selection and understanding how hedge fund investments align with
the rest of your portfolio is vital if you want to effectively manage risk. This is partly why managed
accounts and funds of one continue to gain popularity – they provide the level of transparency
investors need to look at a particular hedge fund investment as part of a broader investment strategy.
The most forward-thinking managers recognize this trend. They’re not coming with an
approach that says, “Make me one of the funds in your hedge fund allocation.” Instead, they’re
looking at the investor’s portfolio and saying, “We’ve looked at your portfolio and here is how
our credit strategy fits in with your broader fixed income allocation.” Now, clearly, this is a far
more operationally complex way to approach it, so the industry is going to have to think through
data aggregation and investor solutions that can meet these kinds of needs. Operations aside, the
biggest takeaway for investors would be: don’t think about hedge funds as a static asset class – the
best results will come from a more rigorous and holistic approach to manager selection and asset
allocation across your entire portfolio.
TO LEARN MORE
For more information on Northern Trust’s services for the hedge fund industry, contact your
Northern Trust Representative or e-mail us at [email protected].
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