Hedge funds’ shrinking returns and escalating investor demands. Downward pressure on fees and unrelenting requirements to have robust operating models. This year, competing forces came together to culminate in the perfect storm. In a year marked by lackluster performance and rising investor expectations, one inevitably asks: Will the challenges of today pave the way to a more successful tomorrow? That all depends on how you respond. As we look back on the year that has passed and look ahead to 2017, a few points come into sharp focus.

Pressures on Hedge Funds

The hedge fund industry continues to be under pressure from several compounding forces. Performance has been pedestrian, with absolute returns challenged by external factors such as unprecedented central bank involvement and relative returns paling in comparison to the historic ongoing equity bull market. Disappointing returns have amplified the discussion among managers and investors as to whether the fees charged are appropriate relative to returns generated. Additionally, investors have become more sophisticated and strategic in developing their portfolios. They have more options than ever within the alternatives universe and are allocating funds to those managers that have a unique offering that is satisfying a specific need of the investor’s strategy. Oftentimes, this results in a shifting of assets from those managers who have been slow to react to managers who have been at the forefront of listening to their investors and creating strategic solutions to keep pace with investors’ needs.

Competition for capital is turning fundraising to a zero sum game

Headlines and news flashes would lead many to think that assets are departing the industry en masse. While there have been certain high-profile outflows, particularly by North American investors, asset levels across the industry remain relatively stable. Institutional investors continue to understand the benefit that hedge funds can provide to their portfolios and remain steadfast in their belief that hedge funds can fill specific needs.

Compared with those forecasting outflows, a larger percentage of investors anticipate increasing their allocation to hedge funds in the coming years. This is particularly evident among European and Asia-Pacific-based investors. The pensions and endowments in these regions tended to have allocated a smaller portion of their portfolio in the past to hedge funds and remain bullish in embracing this asset class as their allocations catch up to those made by North American-based investors.

One in five North American-based investors responded that they are more likely to retrench, the first time that those pulling back have outnumbered those increasing their allocation in the years that we have been polling. North American investors continue to have significant return targets that hedge funds have not been able to deliver, so they are looking for lower fee options in exchange traded funds or other passive investment strategies. Capital flows are rapidly shifting to those managers who have been adapting to the evolving interests of the investor community.

Investor Preferences Are Pressuring Hedge Funds

However, investors’ tastes and specific needs are changing

Investor demand continues to evolve in ways that are forcing the industry to adapt. Investors have become more tactical in how hedge fund products fit into the broader construct of their overall portfolio. Where in the past investors used hedge funds to obtain different market exposures, similar exposures can often now be generated by the investor’s own direct trading or from lower cost alternatives. This is particularly true given the recent equity bull market. However, when market performance changes, so may the role of traditional hedge funds in investors’ portfolios.

Almost 50% of investors expect to continue shifting assets to nontraditional products such as private equity and real assets – strategies that can be harder to replicate elsewhere. As a result, large managers that offer a diverse set of nontraditional hedge fund products are attracting capital and managers that offer solely traditional hedge funds are increasingly challenged.

When it comes to hedge fund investing, investors are seeking specific solutions as part of their broader portfolio and are choosing to invest more through segregated accounts that allow for customization. These vehicles generally give investors more transparency, flexibility and/ or terms that are more closely aligned to the investor’s specific needs. Customization is the name of the game, the exception being for those managers who have unique, niche strategies.

Investor Preferences Are Pressuring Hedge Funds

Management fees continue to be compressed

Lack of performance during a significant bull market and the plethora of lower-cost alternatives, as well as investors’ increased comfort in trading on their own behalf, are causing investors to challenge the fee terms of their funds.

Managers are reporting significantly lower management fees year over year. This trend is particularly evident among the largest managers — where management fees declined by 25 basis points on average. For many managers, not only are the days of 2% management fees in the distant past, but investors have pushed below the 1.5% threshold as the average was reported at 1.35%.

Interestingly, while investors have been focused on management fees, managers are not feeling nearly as pressured on incentive fees. The investor sentiment appears to be that the incentive fees at least need to be earned by the manager, whereas investors believe management fees often turn into an automatic profit center for managers.

Despite this downward trend, investors are not materially happier with their funds’ expense ratios this year relative to last. Only one in five is currently satisfied with the expense ratios of their funds. Therefore, the fee pressure will likely continue. Responding to the trends in investors’ changing preferences increases complexity in operating models and, therefore, puts more of a focus on the need for scale in order to maintain profitability.

Investor Preferences Are Pressuring Hedge Funds

Managers recognize that growth is a necessity to counterbalance industry pressures

Amid top-line revenue and cost pressures, managers continue to see growth as their top strategic priority. Increased assets under management counter lost revenues occurring as a result of fee reductions while also providing stability to the business in a time when the industry is facing volatility and uncertainty.ot surprisingly, the smallest managers are most focused on achieving growth — a goal that has become significantly more important, yet increasingly difficult to achieve. The largest managers tend to place a slightly lower priority on growth, as many have achieved their targets and are now pivoting to ensure that their business is properly supported and scalable. They are focused on how to be more efficient and cost-effective from an infrastructure and operating model perspective.

Relative to bigger and smaller organizations, midsize managers are placing a greater focus on talent management. Many are looking to develop and acquire the right talent that will be imperative for them to continue their growth agenda and compete with the largest managers for investor allocations. Regardless of where each priority is ranked, investments in talent, operational infrastructure, and technology are imperative to support the strategic priority of asset growth.

Investor Preferences Are Pressuring Hedge Funds

Article by EY, see the full survey here.