BNY Mellon looks at how hedge funds need to understand and respond to sovereign wealth funds’ concerns and priorities.
At BNY Mellon’s 8th Sovereign Academy, I chaired a panel with Doug Bendle, Chief Finance and Compliance Officer at Adelphi Capital, and Rory McGregor, Chief Operating Officer at Emso Asset Management. The audience consisted of senior representatives from sovereign wealth funds (“SWFs”), public pension funds and monetary institutions.
Certain themes emerged during the discussions including the consensus that after a period of disappointing returns, sovereign investors now appear more bullish on hedge funds’ prospects. But to gain allocations, hedge funds need to understand SWFs’ concerns and priorities, and articulate how changes in the hedge fund industry address them.
The idea that hedge funds lack adequate governance structures, have poor controls and weak risk frameworks is outdated – and was always an unfair generalisation. But the sector’s historical lack of transparency remains ingrained in many investors’ minds and needs to be challenged by asset managers.
When talking to SWFs, hedge funds need to emphasise their similarities with the broader asset management industry. In co-mingled funds, hedge funds necessarily protect portfolio secrecy; it is their prime intellectual property (although there is daily transparency in managed accounts). However, most hedge funds now produce account risk factor statements and detailed data to enable clients to manage risks and asset allocation – SWFs welcome this transparency.
Hedge funds are changing in other ways that are a selling point for SWFs. Recent headlines1 herald hedge fund growth of $2.5 trillion in the coming years, while others note that few new funds are being created. The two facts are not contradictory: the sector is growing and barriers to entry have increased, largely as a result of regulatory changes. However some of those barriers, such as in EMEA the revised Markets in Financial Instruments Directive (MIFID II) and Alternative Investment Fund Managers Directive (AIFMD), are easier to manage than fund managers may think.
Evolution is being accelerated by hedge funds’ average lifespan of just 5-7 years. With few new entrants and a diminishing pool of surviving funds, a transformation is occurring. Hedge funds were traditionally entrepreneurial vehicles, often spun out of banks or asset managers. Now they are becoming mature and more institutionalised, making them more appealing to SWFs.
In light of these structural changes within the hedge fund industry, those hedge fund managers seeking SWF mandates should emphasise their firms’ stability and maturity. There is strong investor interest in succession strategies given that many funds have in the past been started by, and centred around, an individual. Hedge funds should be ready for prospective investors to make numerous visits to a hedge fund and talk to multiple team members to understand the firm’s culture and mind set.
The ways that investors, including SWFs, access hedge funds is changing. While co-mingled UCITS funds remain popular with some investors, there is growing interest in separately managed accounts. These can replicate existing funds or may involve a manager being given a specifically adapted mandate.
Managed accounts are attractive for SWFs for many reasons. They offer daily transparency, facilitate a bespoke fee structure and ensure that other investors do not determine SWFs’ liquidity. Perhaps most importantly, they allow clients to set investment controls, including limits on borrowing or the use of environmental, social and governance (“ESG”) screens for investment.
ESG investment is becoming an increasingly large component of the investor universe and is especially important to many SWFs, such as Norway’s $1 trillion wealth fund, given their typically long-term outlook. Managed accounts allow investors to tailor portfolios to their specific ESG requirements. Given the breadth of ESG definitions, it can be challenging for hedge funds to demonstrate their ESG credentials: membership of bodies such as the United Nations-supported Principles for Responsible Investment (PRI) is valuable.
Hedge funds’ pricing models are shifting – in ways that are welcome to SWFs. Historically, the hedge fund industry charged 2-and-20. But this structure is changing, with management fees of 1%, or even 75bp depending on the asset class, becoming more common.
Low cost products such as ETFs increasingly appeal to investors in search of beta but investors are willing to pay for alpha (with an agreed beta stripped from performance); in such circumstances, a “1 or 30” structure is becoming more common. Additionally, funds should emphasis clawback and high watermark features to reassure SWFs that they only pay for performance (such features now typically extend to management fees).
SWFs are defined by their cautious approach to investment given their stewardship of public funds. However, the changes taking place in the hedge fund sector, including improved transparency, institutionalisation and the growth of managed accounts are making it significantly more attractive to such investors. The key to success is to engage with SWFs to help them understand the implications of the industry’s evolution and the benefits the asset class can deliver to them.
Note: The views expressed herein are those of the author only and may not reflect the views of BNY Mellon.
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