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Dangers, data and Darwin: hedge funds face the future

Dangers, data and Darwin: hedge funds face the future

  • 16Apr 18
  • Andrew McCaffery Global Head of Client-Driven and Multi-Manager Solutions

Under pressure from innovation, demanding clients and Old Father Time, hedge funds face their fair share of challenges. A rapidly evolving environment will spell the end for those who fail to keep pace. But in a Darwinian industry, those who innovate and adapt will ultimately benefit – and so will their clients.

In a new report, the Alternative Investment Management Association (AIMA) explores these challenges. It also outlines a vision of the industry’s future – one that welcomes the challenge of change.

In recent years, innovative approaches have transformed the investment landscape. Rather than the traditional split between alpha and beta, hedge funds now also have to contend with ‘smart beta’ and ‘alternative beta’ – rules-based approaches that created a more complex market environment. This makes hedge funds’ main job – extracting alpha – significantly harder.

Technological disruption

Like so many other industries, hedge funds are also contending with technological disruption. Artificial intelligence and machine learning are set to play a growing role in the investment management. Smart-beta strategies, for example, are increasingly harnessing artificial intelligence to create more sophisticated offerings.

There’s also the prospect of the technology giants who own the world’s largest data sets – like Google and Amazon – moving into fund management. To hold their own, hedge funds have to rely on data and machine learning to drive their investment decisions.

Then there’s the challenge of recruiting the right people. Traditionally, hedge funds have recruited from business schools. Today, they need to compete with Silicon Valley for talent. With ‘big data’ playing an increasingly important role, hedge funds need individuals who can to gather it, clean it up and analyse it – in short, the brightest quantitative minds.

Nowadays, hedge-fund managers can’t lurk behind their curtains like the Wizard of Oz.

Hedge funds also face growing demands from their clients. Fees and performance have been put under a great deal of scrutiny in recent years, and clients are much more sophisticated and informed. Nowadays, hedge-fund managers can’t lurk behind their curtains like the Wizard of Oz. Their mystique has been torn away, and investors are not prepared to accept unjustifiable costs or excuses for poor performance.

Environmental, social and governance (ESG) concerns are also growing in prominence. That presents an additional performance hurdle for hedge funds by narrowing their potential universe.

And then there’s time itself. The industry may be relatively young, but its leaders are ageing. Succession is now a serious concern for many hedge funds. Until recently, institutional investors looked at ‘key man risk’ as the chances of a manager leaving or falling under a bus. Now, with many hedge-fund managers in their sixties, the industry has to take the risks of retirement or death by natural causes more seriously.

So is all of this bad news? Absolutely not.

The hedge-fund industry has always been fiercely Darwinian, and these increased pressures will simply hasten the evolutionary process.

It would be wrong to say that hedge-fund managers should have nothing to fear, because they should always fear failing to deliver for their clients. But all of these challenges offer opportunities for those who with the adaptability and skill to embrace them.

For the foreseeable future, technology will be an enhancement, not an enemy. As the AIMA report argues, machine learning and artificial intelligence will be used to inform decision-making rather than replace it.

The growing voice of the client should be welcomed too. Hedge-fund firms need to innovate constantly to provide solutions that meet clients’ needs at an appropriate cost. But they will also benefit from a closer alignment of their interests with those of their clients – as through co-investment, where clients and hedge funds pursue high-conviction strategies in tandem.

It is easy to think of ESG considerations as a constraint on investing. But they can be an opportunity. ESG should be seen as a set of consideration that can be used in different ways as an investment risk management tool. It can be a lens through which clients analyse their underlying investments to improve returns and understand their impact on the wider world. This trend isn’t going to go away and the hedge funds that embrace it will prosper.

When it comes to succession, technological disruption may actually provide a solution. As ‘star’ managers are replaced by broader, more data-focused teams, the reliance on any one individual will decline. That should provide welcome stability for strategies – and reassurance for investors.

In the long run, what’s good for investors is good for the industry. If the field becomes less crowded, then so be it; Mayfair property prices will do all right. Those firms that adapt to clients’ needs and embrace technological change will thrive. The challenge of the new may be daunting – but it’s ultimately positive for the only people that matter: the clients.





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