Credit Suisse: Institutional Investors Looking to More Favorable Hedge Fund Fee Structure

More institutional investor money will flow into hedge funds in 2017, according to a Credit Suisse annual hedge fund investor survey. The 320 institutional investors responding to the survey, who make up more than $1 trillion in hedge fund investments, anticipate a 3.5% increase in net hedge fund inflows for 2017. And 87% of them are looking to either hold constant or hike up their hedge fund allocations.

Investors are making a push for better return terms, with 61% pointing to at least one hedge fund manager they work with shooting for a basic hurdle rate. And 57 % of the institutional investors have seen a reduction in the past 12 months in the management fees they pay hedge funds.

This comes at a time when investors such as Warren Buffett have criticized hedge funds for their high fee structure. The typical hedge fund fee setup rewards their managers with 2 % of the assets under management and 20 % of any profits.

In addition to anticipating more favorable terms on their fees, other notable developments these institutional investors are looking to in 2017 include more funds shutdowns. They also anticipate that hedge funds will be impeded by fewer regulations in 2017.

Robert Leonard, global head of capital services at Credit Suisse, said, “Institutional investors remain strongly committed to hedge funds playing a role in their portfolios. However, they also appear to be following through and making real changes to their hedge fund allocations. This includes increased concentration with funds in their portfolios, adding strategies that are less correlated with equities and terms that better align their long-term interests with those of their managers.”

A mere 30 % of these investors are happy with the returns on their hedge fund holdings this year, going by those who said the investments met or surpassed their return expectations, a major falloff from the 45 % of investors who reported the same for last year. For 2017, the institutional investors are targeting a 7.2 % annual return for their hedge fund holdings, although the average industry return was 5.5 % for 2016.

Lack of performance was the main factor driving redemptions from hedge funds, with 80 % of institutional investors pointing to the disappointing returns of individual managers as a cause to exit a hedge fund investment. Changes at a manager, whether in terms of personnel changes or “style drift” also caused 52 % to opt out of their holdings.  

The hedge fund strategy that the institutional investors most prefer for 2017 is “global macro-discretionary”, with 26 % net interest in this approach. Fixed income arbitrage and emerging market equity strategies are the secondmost preferred strategies, with 18 % overall demand for these approaches.

The investors are moving more towards equity funds focused on specific sectors, rather than general equities strategies. Favored equity sectors include healthcare and financials. Investors are also more interested in quantitative strategies this year, as well as hedge fund startups, with 44 % investing in a startup last year, and 75 % of these investors receiving favorable terms on such investments.

As to what factors matter when it comes to selecting a hedge fund, institutional investors mostly look to the hedge fund’s returns after fees, no correlations with the institutional investors’ other investments, the caliber and risk management skills of the managers, as well as the overall stability of the core team.

By Poonkulali Thangavelu