Although 2016 was far from a breakout year for hedge funds, performance improved over a lackluster 2015, and managers have a more positive outlook for 2017 as stock markets are boosted by President-elect Donald Trump’s plans to lower taxes, deregulate and spend on infrastructure.

Data provider Eurekahedge reported hedge funds were up 3.53 percent through November 2016, double the modest gains of 1.73 percent over the last year.

But fees and performance remained at the top of the list of investors’ concerns for the industry as the sector continued to trail the equity markets.

Cheaper passive investments have made inroads into the alternatives market by replicating some hedge fund strategies at a fraction of the cost.

Whether these smart beta exchange traded funds can fare in the same way in the choppier weather of more volatile markets remains to be seen. But alternative beta, in combination with the relatively modest performance of hedge funds, have raised the question of costs for institutional investors.

Pensions funds that made up a growing share of hedge fund investors over the past decade now set the tone. They put pressure on fees and demand customized investment structures and more detailed reporting on the funds’ positions to better align the hedge fund investment with their overall portfolio.

Others have scrutinized their allocations more critically after the unimpressive performance of hedge funds overall.

In a year when the S&P 500 gained 9.8 percent through Nov. 30, equity hedge funds returned a meager 4.9 percent, according to data provider Hedge Fund Research.

As a result, some investors have taken their money out of hedge funds altogether, pushing into better performing alternatives like private equity, real estate and infrastructure funds.

Hedge Fund Research predicts that 2016 could be the first year of net withdrawals from the sector since 2009. The number of hedge funds has also declined and is lower than in the past three years.

MetLife is one of the institutional investors that plans to radically reduce hedge fund investments in 2017. The firm said in December that it will bring down its hedge fund allocations from $1.8 billion to $800 million. This followed moves by CalPers, America’s largest public pension fund, which announced two years ago that it was eliminating its $4 billion hedge fund program. The New York City Employees’ Retirement System followed suit in April last year, along with a slew of smaller U.S. pension funds.

Fees

Institutional investors named cost and complexity as two of the main criticisms of their hedge fund investments. High fees and restrictive terms are less of a concern when the asset class produces outsize returns but amplifies once performance wanes.

“Allocations are hard to come by, so investors are really driving the fees,” said Dennis Westley, managing director, North America, Apex Fund Services, at the Campbells Fund Focus conference in December.

To attract further capital in a difficult fundraising environment, hedge funds had to respond.

Fee cutting and flexibility around incentives have become the norm in the industry.

Most funds used to command a management fee of 2 percent of assets under management and a performance fee of 20 percent of the profits. On average, this has come down across the board to about 1.65 percent and 18 percent, respectively. But depending on the size of the fund or whether it is a startup or established fund, fees can come down much lower. About two-thirds of funds offer some type of fee discount.

Managers give discounts depending on assets under management or time invested to reward early investors. Other structures use crystallization periods for performance fees, minimum return thresholds or hurdles for incentive fees, or they tie performance fees to the size of the return.

Managers are also looking for stickier capital and apply discounts for longer lock-up periods or reward particularly large investments.

“The most obvious one is longer lock-ups for lower fees,” said Westley. “We have seen that over and over again in the past months.”

In addition, founders’ shares, which incentivize early investors with discounted fees, have become more widespread.

For fellow panelist John McCann, CEO of Trinity Fund Administration, the convergence of the sector is part of the problem. Since hedge funds went mainstream, institutional investors have come in and set the scene.

“You have got pressures on fees, you have got hurdles, benchmarking. And yet performance is still not there. Ninety percent of the assets in the industry are controlled by 10 percent of the managers. And they are average,” he said. “Where are the alpha pickers? If they are vanilla strategies pretending to be hedge funds, I think that’s the problem. They lost their way.”

Looking at the industry’s average returns collated by data provider Prequin, large funds have indeed been the problem of the industry as small funds have shown the best returns, and emerging funds also performed better than institutional players.

This can still be an opportunity for the industry going forward, noted Ronan Guilfoyle, founder of Calderwood, an asset management fiduciary firm that offers directorship services.

“If you are diversifying your portfolio, you are going to allocate to emerging managers, emerging markets, as well as having your private equity and hedge piece. That’s traditionally where a lot of the best returns have been: the small nimble managers who have to do well,” he said. “The new managers that we are talking to are saying there is some excitement out there, some interest.”

However, he acknowledges that it will take time for these startups to get past the $100 million hurdle required to develop a critical mass in today’s market.

“You have to make significant investment in infrastructure up front on top of that outperformance for investors to take notice. The days with two guys and a Bloomberg and friends and family money are long gone,” he said.

Institutional investors are now demanding detailed information from managers similar to the reporting required by regulators.

While investors do not want to invest blindly, and ensure they know the risk characteristics of their investment, it puts them at odds with managers who want to protect their intellectual property.

Still, the volume and velocity of reporting of risk metrics has exploded, McCann said. In Europe, this is largely due to regulation, but the U.S. is seeing the same trend, according to Westley.

In any case, the infrastructure needed to report the vast amounts of data and analytics is costly. Managers must choose between adding staff and outsourcing.

Investors also demand more customized investments. EY’s annual survey of the hedge fund industry found that 42 percent of investors aim to shift from commingled hedge funds to customized vehicles and segregated accounts.

The move to customization is prompted by the desire to gain more control, flexibility and a more intimate understanding of the investment strategy.

Many institutional investors will turn to hedge funds only to achieve specific exposures, noted EY partner Jeff Short at the firm’s Hedge Fund Symposium in Cayman in December.

Top risk for the industry

Yet, EY’s survey showed only 8 percent of investors believe hedge funds can offer strategies or exposures that cannot be obtained elsewhere. Changing investor demands were thus the top risk for the hedge fund industry, the survey found. About half of all investors said they expect to shift their hedge fund investments to other alternative investments such as private equity, real assets and venture capital over the next three to five years.

Family offices and sovereign funds have already moved significant capital out of hedge funds, some of it going into private equity and real assets, said McCann.

“That may pause now because of Trump,” he said.

Although President-elect Trump said he would repeal the carried interest benefit for hedge funds and private equity funds, industry insiders are not sure whether he is going through with the proposal, nor whether he is bluffing with his stance on trade.

The stock market, however, has reacted positively to the prospect of large-scale deregulation, tax reform and a general pro-business stance of the new administration.

Banking stocks surged 20 percent since the U.S. presidential election. For McCann there are obvious sectors that should benefit. With a divergence of interest rates and the strengthening of the U.S. dollar, investors are showing strong interest in U.S.-centric businesses, he said.

“We have had many board meetings where certain sectors are anticipating to benefit. Everybody is anticipating deregulation. I think U.S.-centric will do very well. I think infrastructure sectors will do very well, certain parts of energy.”

Guilfoyle said he is not convinced that a lot of capital went from hedge funds into private equity.

“A lot of the money will be sitting on the sidelines. If you are diversifying your portfolio, you are already allocating to private equity. You don’t want to be overweight. So, it is a question of the mix. Maybe there is a bit of cash on the sides and that will come back into the hedge fund space in two years.”

Guilfoyle is also upbeat about the industry’s prospects in the near term.

“We have seen a lot of activity and out of the U.K. and Switzerland. We see new launches all the time and that has steadily increased as the year has gone on,” Guilfoyle said. “I think we will see more launches and more spinoffs from the larger managers.”

Westley agreed. “The last several months we have seen an uptick, not just in the U.S., but in the Asia Pacific region.”

Whatever direction the Trump presidency is going to take, panelists agreed, the uncertainty created by the political situation and the volatility from rising interest rates will form an environment with many opportunities for hedge funds.

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