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If hedge funds are to remain competitive and attract greater wallet share, they will need to digitalize their operating models. Many managers have taken note and are increasingly using next-generation technologies to improve their investment processes, augment customer experiences, and streamline operations.
Broadridge surveyed senior leaders at hedge funds about their digitalization and next-gen tech strategies as part of its 2023 Digital Transformation Study of C-suite executives and direct reports from 500 financial firms globally. So what were the main findings?
Hedge fund performance has been adversely impacted by different headwinds, including multi-decade high inflation, sharp interest rate rises, falling equity markets, renewed fears about banking stability, and the looming threat of a recession. In 2022, the average hedge fund suffered losses of 4.2% according to Institutional Investor, although returns this year have been fairly flat. Some hedge funds are re-thinking their liquidity terms, and introducing lock-up periods to improve their balance sheets and protect themselves against potential outflows.
Despite this tough return environment, inflows into hedge funds have not wavered, with the industry attracting $50 billion in Q1 2023, bringing its total AUM (assets under management) to $3.88 trillion.
As with many other asset classes, hedge funds are being saddled with rising costs and new regulations; this is particularly true in the U.S., where the Securities and Exchange Commission (SEC) is proposing more stringent reporting requirements for the industry. At the same time, managers are inundated with detailed reporting requests from large institutional investors, taking a toll on middle- and back- office operations.
Compounding matters further is lower hedge fund fees, which have fallen to levels not seen since the immediate aftermath of the 2008 financial crisis. Fifteen years ago, a typical hedge fund could charge investors a 2% management fee and a 20% performance fee — this is no longer the norm. Nowadays, the average hedge fund’s management fee stands at 1.35%, while its performance fee is closer to 16.01%.
Hedge funds are facing growing competition as some institutional investors scale back their exposures to the asset class in favor of private market strategies, such as private equity, which have delivered robust performance during the last 10 years. Other investors are looking to save money by increasing their allocations to low-cost index trackers, often at the expense of hedge funds.
To stay relevant in this rapidly evolving market, hedge funds are digitalizing their operating models and embracing innovation.
Broadridge’s latest digital transformation study finds 58% of hedge funds say digital transformation is their most important strategic initiative. A failure to invest in new technology or update legacy systems could leave managers disadvantaged in a difficult environment for raising capital.
Hedge funds are allocating substantial resources to technology: respondents say 26% of their overall IT budget is currently allocated to digital transformation, a jump from 2022 when that figure stood at 13%.
Hedge funds intend to boost investment into cloud platforms and applications by 26%, cybersecurity by 24%, and data analysis and visualization tools by 22% over the next two years. Such solutions will help managers centralize and systematize their data, enabling them to augment their performance, streamline operations, and improve client (and regulatory) reporting.
Innovation is also high on hedge funds’ agendas. Managers plan to increase spending on AI (Artificial Intelligence) and machine learning by 20%, and Blockchain by 21% over the next two years.
Relative to traditional asset managers and private capital firms, hedge funds are among the most enthusiastic adopters of AI. Eighty-one percent of respondents say the technology is already changing the way they work.
Some CIOs are leveraging AI to complement their investment decision making process by using it to analyze vast data troves, identifying potential market movements and trends. Other hedge fund managers are integrating AI into their operations to optimize middle- and back-office activities, such as fund accounting, regulatory compliance, and client reporting.
Shifting towards AI deployment versus manual intervention in these non-revenue generating areas can help hedge funds net sizeable cost synergies. However, if firms are to capitalize on the AI boom, they will need to make substantive changes to their operating models. For AI tools to function, they require high quality data inputs. Hedge funds therefore need to make material improvements to their data management and governance, if they are to leverage AI effectively.
There are potential blockchain use cases for hedge funds as well. Blockchain tools can help improve transparency by enabling managers to monitor complex assets more easily, and allow investors to view their holdings in real-time. A more enjoyable investor experience will help managers not only retain clients, but also win new mandates.
Although the cryptocurrency space has been plagued with volatility since its inception, institutions are becoming more interested in the idea of asset tokenization, whereby real-world assets (i.e. equities, real estate, etc.) can be converted into digital tokens and traded on a Blockchain. As tokens can be fractionalized, it will be cheaper for investors to acquire them, which could help facilitate greater liquidity across illiquid asset classes.
Innovation is not without its challenges, however. Forty-five percent of hedge funds are stymied by inflexible systems and inadequate IT infrastructure, among other barriers impeding their digitalization journey. Forty-three percent blamed talent shortages for setting back their transformation agenda. Another 34% said staff resistance to change is causing problems, and 32% say they have insufficient budget to invest in innovation.
Despite this, hedge funds recognize that if they are to thrive in the future and attract new mandates, then they will need to make substantial investments in their technology systems. Having a clear plan in place to adapt to the ever increasing pace of technology-driven change is essential as next-gen tech matures and drives greater disruption.
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