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Having generated returns of more than 10% last year, hedge fund performance has since declined, with the HFRI Fund Weighted Composite Index down 2.7% YTD in 20221 Amid these challenging circumstances, Broadridge examines what the coming year could hold for the hedge fund industry.
2021 was an excellent year for hedge funds, with industry AUM (assets under management) surging past the $4 trillion mark. In contrast, this year has been challenging, with the average manager incurring losses of 5.9%, according to HFR. However, over the same period, the S&P 500 index lost roughly 20%. Only macro strategies have seen positive returns in 2022 driven by their low correlation to short-term volatility. Many industry observers expect this outperformance to drive additional institutional allocations to hedge funds.
Whereas previously, only large hedge fund managers leveraged tools such as AI (artificial intelligence), machine learning and Natural Language Processing to identify performance opportunities, mid-sized managers are now starting to follow suit. Again, this reinforces how important it is for managers to check that the data being inputted into their systems is accurate. In operations, hedge funds are increasingly automating their core systems and eschewing manual processing, facilitating significant cost benefits. Wider adoption of technology across the front, middle and back-office will be a recurrent theme in 2022.
Labor shortages are threatening the wider global economic recovery, and it is an issue that is starting to affect some hedge funds. With many experienced hedge fund staff leaving for other roles or leaving the industry altogether, some hedge fund jobs are going unfilled. In areas such as operations, this is forcing hedge funds to outsource certain functions. With these labor scarcities likely to persist, the need for hedge funds to outsource their operations will only grow.
Investors' appetite for ESG (environment, social, governance) products is growing, and hedge funds are being forced to respond. Although some hedge funds are yet to be convinced by the merits of ESG investing, 40% of managers responded in a BNP Paribas Securities Services study that they are integrating ESG into their decision-making processes. As managers look to widen their investment appeal, many will increasingly incorporate ESG into their portfolios next year. However, the industry does need to be careful to avoid greenwashing, especially as the US Securities and Exchange Commission (SEC) is starting to fine money managers for transgressions in this area.
The prime brokerage industry had a challenging year in 2021, with several prominent players incurring sharp losses linked to a highly leveraged family office, which subsequently collapsed. This debacle has already prompted one major banking group to exit prime brokerage altogether, while another has retreated from providing cash prime brokerage in the US and Europe. As a result of the fall-out, there will likely be greater regulatory oversight of certain synthetic instruments, while prime brokers will undoubtedly sharpen their risk management practices. This also opens the possibility of further consolidation in the prime brokerage industry. The hangover from this episode will last well into the coming year for prime brokers.
US regulators are taking a more active role in overseeing hedge funds by imposing additional transparency requirements on the industry. For instance, the SEC is now demanding that hedge funds report details about their short sales if they exceed a certain threshold, and share with investors more information about performance, fees and expenses. Meanwhile, proposed revisions to the Form PF reporting template will oblige large hedge funds to inform regulators of any significant stresses facing their organizations within one day of them occurring. Most significantly, the SEC is widening the scope of trading activities which will force firms to register as broker-dealers, in what could catch out some hedge funds, thereby adding to their already significant compliance workloads. Expect regulation to take its toll in 2022 and 2023.
1 Hedge Fund Research – August 5, 2022 – Equity Hedge Funds Lead Industry Gains to Begin Second Half of 2022
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