A Look Ahead: What Hedge Funds Should Consider Heading Into 2015

Dec 1 2014 | 11:21am ET


As 2014 winds down, Northern Trust Hedge Fund Services executives took some time to share their outlook on trends facing the industry in 2015.

What are the biggest regulatory challenges you think the industry will need to address in 2015?

Carl LingenfelterCarl LingenfelterCarl 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.

What do you think will be the industry’s most significant challenge in 2015?

Peter SanchezPeter SanchezPeter 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.

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 Peter CherecwichPeter CherecwichCherecwich, 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.

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 BoydJeff BoydJeff 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.

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.

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