Hedge Funds Seek Critical Mass While Sustaining Profitable Margins
Insights from J.P. Morgan's Annual Benchmarking Survey of the Hedge Fund Industry
As a whole, the hedge funds participating in our survey report that they are growing steadily. Beyond a notable fall-off in distressed debt, most are continuing with the same strategies using the same instruments. What has changed is the cost of doing business and the ability to pass those costs along to their clients.
Rapidly developing cycles of obstacles and opportunities continue to play a dynamic role in the operational direction of hedge funds. J.P. Morgan's Prime Brokerage Consulting Group recently completed analysis of a four-month survey of hedge fund clients, aggregating key insights concerning the industry's expansion and factors influencing growth. "Our clients' feedback conveys some of the response to regulatory change and toward new efficiency trends," says Kumar Panja, Global head of Prime Brokerage Consulting. "The cumulative data we've built provides some unique insights into directional shifts over time as well as certain continuing patterns for the industry as a whole."
Now in its third year, the survey examines diverse elements of hedge fund structures and strategies. Key findings include the growth of separately managed accounts, changes in staffing and the adjustment of performance fees, among others. "With institutional investors pushing back on fees, we expected to find that smaller to mid-sized hedge funds would be reducing headcount," said John Cotronis, NA head of Prime Brokerage Consulting. "Instead we found that they were adding staff, holding the line on administrative fees and compromising largely on their performance incentives."
Fund strategies and asset allocation
Strategies employed by hedge funds remained largely unchanged from 2010 through 2012 with the notable exception of credit/distressed. Among those strategies, allocations to commodities have decreased sharply.
Overall, the strategies employed by hedge fund respondents were fairly consistent from 2010 through 2012 with the exception of credit/distressed, which declined from 55 percent in 2012 to 48 percent in 2012. This decrease may reflect what hedge funds view as a diminishing opportunity set in the credit arena since little room may be left for price appreciation.
Among the strategies employed by respondents, the AUM allocated to each also has remained fairly stable with two notable exceptions: commodities/CTA fell from 27 percent of AUM in 2010 to only 13 percent in 2012. Correspondingly, the number of firms that have ceased trading in commodities rose from 17 percent in 2011 to 25 percent last year. These declines correspond with what many view as the end of the commodities super-cycle and poor performance among managers with material commodities exposure. By contrast, allocations to statistical arbitrage surged from 14 percent in 2010 to 38 percent in 2012.
Separately managed accounts
Separately managed accounts have grown steadily in recent years, reflecting the rising demand for customized, bespoke solutions in lieu of broad, commingled vehicles.
Not surprisingly, the survey revealed that separately managed accounts (SMAs) have grown steadily in recent years in response to rising demand for customized fund solutions. Firms that manage SMAs rose from 59 percent in 2010 to 63 percent in 2012. The survey also showed a willingness to raise assets in vehicles other than commingled partnerships. Almost half of the participants would consider the use of funds of one and SMAs to raise assets.
Asset classes used
The survey measured the types of asset classes that respondents use for trading and investments, ranging from equities to FX and ABS. Notable changes included CFDs, which shot up from 31 percent in 2011 to 48 percent last year; commodities, which fell by two percentage points; and sovereign debt, which rose from 24 percent in 2011 to 34 percent in 2012. The dramatic increase in the use of sovereign debt likely reflects receding tail risk among eurozone countries.
Year-to-year country exposures among respondents were largely unchanged with the exception of Japan, to which hedge funds increased their exposure from 38 percent in 2011 to 47 percent in 2012. This increase reflects greater short exposure to the JPY trade and to Japanese equities as a result of "Abenomics."
Within different peer groups in the survey there has been movement on financing sources. Specifically, equitycentric funds with $500M to $1B in AUM have moved dramatically away from Reg-T margin finance towards portfolio margin, which could afford higher leverage levels across a broader spectrum of securities.
In response to fee pressure from investors, hedge funds have adjusted performance fees more while management fees have remained stable.
Our many conversations and meetings with clients confirm that the fee pressure from investors remains very real. Consequently, the survey revealed a decline in the number of hedge funds charging a 20 percent performance fee (90 percent in 2011 versus 82 percent in 2012) and a slight increase in the number of funds charging a 15 percent performance fee (three percent in 2011 versus six percent last year).
Despite fee pressures, the number of hedge funds charging a two percent management fee has remained quite stable. While 39 percent of respondents charged a two percent fee in 2011, 37 percent did so in 2012.
At the time of the survey's completion, 18 percent of U.S.-based survey respondents indicated that they planned to look into onshore European fund regimes, although 65 percent of that number will examine opportunities through UCITS, as alternative UCITS funds and AUM continue to grow.
Somewhat counter-intuitively, 57 percent of the respondents expressed no concern over the Alternative Investment Fund Managers Directive (AIFMD), which took effect in July 2013. Such responses may reflect the lack of consensus among legal practitioners regarding the compliance measures required with respect to the AIFMD. Since the survey date, there has been increasing interest in understanding the various facets of AIFMD and the impact on the way hedge fund managers conduct business going forward.
There has been a steady uptick in the number of firms planning incremental increases in headcount, reflecting ongoing growth in the industry.
There was an incremental uptick in the number of funds planning to increase headcount; 48 percent indicated such plans in 2011 and 49 percent indicated such plans in 2012. While the increase is slight, it reflects continued growth in the hedge fund industry despite the headwinds faced last year. The one notable exception has been the dramatic decrease in traders employed at funds. The average number of traders across all fund managers dropped from eight in 2010 to just over two in 2012.
The survey revealed a slight year-over year increase in the percentage of firms' technology budgets devoted to services and data (plus one percent) and a corresponding decline in the allocation to software investment (minus one percent). This pattern reflects hedge funds' growing use of cloud, ASP and SAAS solutions.
A growing number of allocatorsare investing directly in hedge funds,thus circumventing hedge fundsof funds.
Direct hedge fund investments
According to the survey, the number of investor relationships among respondents increased from 90 in 2010 to nearly 160 in 2012. That trend is indicative of the fact that, increasingly, investors are allocating directly to hedge funds, thus disintermediating funds of funds.
Nearly 60 percent of the respondents indicated that the composition of their investor base has become increasingly more institutional. That pattern reflects the ongoing institutionalization of the hedge fund investor base, which once was comprised mainly of family offices and ultra high net worth individuals but increasingly is made up of pensions, endowments and foundations, and sovereign wealth funds.
The bottom line
As a whole, the hedge funds participating in our survey report that they are growing steadily. Beyond a notable fall-off in distressed debt, most are continuing with the same strategies using the same instruments. What has changed is the cost of doing business and the ability to pass those costs along to their clients. As hedge funds, particularly smaller funds, strive to keep up with new regulatory and market demands, they are planning to increase headcount or otherwise increase operating costs. Achieving critical mass becomes a paramount concern, as efficiencies of scale may well be needed to sustain a profitable fund. In the face of increasing competitive pressure, however, many funds must compromise on fees, particularly performance fees, to attract new assets. We believe that this delicate balancing act, between the need to grow and the ability to sustain a profitable pricing model will define the agenda for many funds for years to come. We look forward to exploring these issues further in our next survey.