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Dangers, data and Darwin: hedge funds face the future

Data and Darwin: Evolution of hedge funds

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

In a new report, the Alternative Investment Management Association (AIMA) explored these challenges. It outlined 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.

Increasing role of artificial intelligence and machine learning

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.

To hold their own, hedge funds have to rely on data and machine learning to drive their investment decisions.

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 analyze it – in short, the brightest quantitative minds.

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.

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? No.

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

It would be wrong to say that hedge fund managers should have nothing to fear, because there is always the fear of failing to deliver for 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 argued, 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 funds 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 analyze 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 also good for the industry. If the field becomes less crowded, then so be it. We believe those firms that adapt to clients’ needs and embrace technological change will be the ones to thrive. The challenge of the new may be daunting, but it’s ultimately positive for the only people that matter: the clients.

Important Information

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

ID: US-160418-63206-1