Alfred W. Jones opened the doors of the world’s first hedge fund firm nearly 70 years ago. He could not have known it at the time, but his innovations would sow the seeds of a new industry that would change the face of investing.
The story of the hedge fund industry since then has been one of continued growth and innovation. Today’s hedge fund firms trade in everything from vintage wines to risk factors, using cutting-edge mathematics to manage risks and even to execute trades—the stuff of science fiction in Jones’s days.
Many question what the future holds for the hedge fund industry, given its history of innovation. What kind of products will hedge fund firms offer to their new investors? How will they reconcile profits with social responsibility? Will hedge fund firms even exist in the future, or will they have been replaced by artificial intelligence systems? If they do still exist, and are still staffed with humans rather than machines, how will hedge firms navigate the coming generational change in leadership?
The Alternative Investment Management Association (AIMA) and Aberdeen Standard Investments (ASI) decided to answer those questions.
This paper is based on conversations with 25 of the leading figures in the hedge fund industry, from founding principals at hedge fund firms, to senior management at multi-asset managers, to industry academics. Collectively, they represent close to 300 years of leadership experience in the hedge fund industry and over US$500 billion in assets under management.
What we found was an industry embracing change.
1. A PARADIGM SHIFT
The hedge fund industry is experiencing a significant transformation. In the past, customers tended to use unconstrained investors such as hedge funds to achieve alpha, while relying on traditional active and passive fund managers for beta. This industry model is now being replaced by a new range of investment solutions, each tailored to the needs of an increasingly diverse investor universe. Collectively, these new solutions constitute a paradigm shift in the hedge fund landscape.
Central to this shift are “smart beta” and “alternative beta.” These products have emerged from years of financial innovation, and offer investors access to the benefits of alternative investments—from diversification to the potential maximization of returns—at a much lower cost than has historically been possible. Banks and mainstream fund managers are replicating these hedge fund techniques. However, thanks to their experience pioneering these solutions, hedge funds will be well placed to use them to help meet investors’ risk and return goals.
2. ENDURING ALPHA, ENDURING VALUE
Despite what some critics have said, alpha is not becoming impossible to produce. Alpha has, and always will be, the rarest form of returns. Purely picking individual securities to gain an edge is increasingly difficult, given the wider availability of once-valuable financial information and the fact that markets are more efficient than in the past decades. Furthermore, some investment strategies have delivered returns quickly in recent years. Consequently, expectations of immediate success from other investment strategies have risen among investors; the majority of investment strategies must now work on compressed time horizons. Some of those strategies simply cannot realize optimum performance in such short timeframes.
Alpha has been, and always will be, the rarest form of returns.
Hedge fund firms can still deliver alpha through a combination of skill, knowledge, market timing, and judgment. They will need to compete harder to produce alpha, and evaluate ways of using different investment timeframes to maximize their advantage when doing so. Given the rarity of the skill needed to deliver alpha, investors will continue to pay a premium to those who can deliver it consistently.
3. MAN AND MACHINE LEARNING
Artificial intelligence and other cutting-edge quantitative techniques will soon become crucial to the hedge fund industry. Both systematic and discretionary hedge fund firms will need to use machine learning (a subset of artificial intelligence) in order to process information and make the best investment decisions possible. Artificial intelligence will be particularly important in short-term trading; firms operating in this area will likely need sophisticated artificial intelligence capabilities.
We think that the complexity of financial markets data means that, for the foreseeable future, artificial intelligence will not be able to make accurate long-term financial predictions. Therefore, it will not usurp the integral role of humans in the investment world. However, hedge fund firms that do not develop artificial intelligence capabilities to aid their human employees may soon find themselves at a competitive disadvantage.
4. INVESTING RESPONSIBLY
While good governance has always been important to investors, different forms of responsible investment are now becoming more widely adopted across the hedge fund industry. Today’s investors expect their investments to reflect their values and to account for long-term environmental risks; hedge fund firms are responding to investor demand.
While responsible investment can, in some cases, act as a constraint on a manager’s ability to generate profits, new technology is allowing hedge fund firms to implement responsible investment at a low cost. Some hedge fund firms are exploring whether the use of responsible investment can deliver outperformance. While not every hedge fund firm will adopt responsible investment in the near future, the confluence of investor demand, improving data and technological capacity most likely will push more managers to offer their investors a greater level of responsible investment opportunities.
5. THE FIRM OF THE FUTURE
The shift towards systematic investing is pushing the hedge fund industry to hire new talent. Many hedge fund firms now hire highly quantitative talent—such as mathematicians, physicists, and computer scientists—instead of the traditional business school graduates. They are also moving beyond the industry’s traditional talent pools and hiring from a diverse range of identities and backgrounds. This is pushing hedge fund firms into direct competition with the technology industry for the brightest talent.
In order to get the most out of this talent, and to lure it away from the technology industry, hedge fund firms are changing how they work. In order to succeed in the future, hedge fund firms are encouraging internal collaboration and flattening their internal hierarchies.
Further, many hedge fund principals are now looking to institutionalize their firms and ensure a smooth handover to the next generation of leaders. Consequently, succession planning is becoming more common in the industry. Selling a portion of the management company ownership to external shareholders is one strategy being used by hedge fund firms to drive growth.
6. PARTNERING WITH INVESTORS
Hedge fund firms will focus on building closer relationships with their investors. As the hedge fund industry evolves and investor demographics become increasingly heterogeneous, multi-managers, with their resources, experience and infrastructure, are well placed to help investors access new opportunities tailored to their needs. There will also be greater development around co-investment options (in which a hedge fund manager invests in opportunities alongside its investors, working exclusively together on high-conviction investment strategies), an even greater level of transparency, and true knowledge sharing as managers and investors align their interests more closely.
In our view, the hedge fund firms that are most likely to be successful will be those that prioritize how they are perceived by investors and the wider market. Central to such an outcome is the importance of trust, not only between hedge fund firms and their investors, but also between the industry as a whole and the wider public.
7. SUSTAINABLE SUCCESS
Hedge fund firms are being forced to focus more on their business and distribution models, as they face increasing competition both from each other and from traditional asset managers. Hedge fund firms can no longer only focus on their investment products—they must think about how best to run their firms as institutionally-friendly asset management companies. As competition for capital flows intensifies, retail investors are likely to become an increasingly important source of growth for hedge fund firms. This is driving hedge fund firms to rethink their distribution models. Consequently, firms are exploring how to deploy best-in-class digital and mobile technologies to deliver the most cost-competitive solutions possible to their clients.
Diversification does not ensure a profit or protect against a loss in a declining market.
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.