In this third article in our series on convergence trends, we explore how hedge funds may find exciting opportunities in the retail market.
Making detailed long-term predictions is difficult at any time, let alone during unprecedented times. In a world with significant macro-economic uncertainty and volatility, both traditional and alternative asset managers are facing an ever-greater squeeze on their margins, amidst increasingly complex demands from investors, rising operating costs and the uncertainty of rate rises.
In this complex landscape, the rulebook for fund managers is being torn up. Traditional and alternative managers are embracing a huge range of strategies and vehicles across the liquidity spectrum. Distribution holds the key as investors aim to be closer to their funds and new, digitised solutions and disintermediated distribution models offer new opportunities to do this. In this article we will explore how hedge funds are tapping into these new investor demands, raising capital through new avenues and markets, while developing an innovative product mix and managing the increased operational requirements that this brings.
Retail investors: a new frontier for hedge funds
The retail investor market has not traditionally been a focus for the alternatives market. After years of low-interest rates, and now, the recent volatility of traditional stocks and bonds, many households are turning to alternative assets as a source of diversified return.
According to McKinsey, the projected retail share of alternatives has the potential to more than double to 5% in the next three years – adding to between $500 billion and $1.3 trillion in new capital. For hedge funds and other alternative investment managers, retail investors are traditionally smaller in size, less ‘sticky’ than institutional clients, and have an entire industrialised distribution ecosystem built around them.
However, many hedge fund managers have started to overcome some inherent barriers to the retail market, such as reinforced regulatory requirements, and we see several funds trying to tap into the market. Many are starting to offer liquid alternative structures (‘Alternative UCITS’ in Europe and ‘40 Act Liquid Alternative Mutual Funds’ in the US), offering the benefits of a regulated, liquid mutual fund wrapper with selected hedge fund strategies and also some investment restrictions on leverage, short-selling, concentration and asset class limits.
An increasing number of managers are also launching so-called ‘hybrid’ funds, which combine illiquid investment exposures with the liquidity terms and trading strategies of open-ended funds. These funds can provide investors with more choice, flexibility and portfolio diversification, bringing the prospect of both enhanced returns and periodic income streams from a range of asset classes.
Realising the potential
There is a growing window of opportunity for hedge funds to expand their distribution and their investor pool, but this is not without its challenges. Hedge funds’ operating models are designed around the needs and expectations of an investor base who are used to lengthy onboarding processes of several months at a time, detailed application process and reporting requirements. Hedge fund investors are accustomed to enhanced due-diligence, bespoke performance fee methodologies and other restrictions associated with alternative asset classes such as lock up periods with monthly/quarterly liquidity.
In contrast, retail investors expect immediate access to their assets, near-instant onboarding, and more flexible communication and reporting systems. Through our decades of experience in outsourced fund administration services and our global transfer agency network, the Securities Services business of BNP Paribas provides efficient due diligence on investors and have all the reporting systems in place to offer granular and up-to-date information for investors. We leverage industry-leading platforms, allowing our expert staff to manage our client solutions and handle any operational challenges. We are also currently working on solutions to digitalise fund application forms to engage better with younger and tech-savvy investors.
Another challenge faced by hedge funds is the greater barriers for entry in each market, where regulations differ greatly and are often much more stringent for funds targeting retail investors. At Securities Services, we have the benefit of having experienced local teams based in every major market around the world. On the ground, we have an in-depth expertise on market practices and local regulations, which can help firms establish themselves wherever they need to expand next.
With the increasing focus on liquidity in recent times, especially for retail investors who require daily dealing facilities, it is key for hedge funds to be able to provide the necessary liquidity while maintaining their investments in more illiquid and diversified asset classes. At BNP Paribas’ Securities Services, we can support our fund managers clients with a comprehensive solution set. In additional to our core administration services, custody and prime brokerage, ancillary services such as financing can provide an important value add to the Hedge Fund and Liquid Alternative Manager.
Going to the source: the explosion of D2C
In recent years, the DIY investor market has exploded as a tech-savvier generation emerges. They are hungry for returns and have access to the market via technology. The existing multi-tiered fund distribution model with multiple stakeholders is complex and there is a natural demand to simplify it. This younger generation of investors is used to simplicity and directness in their service relationships and technology, and they expect this from their investments.
This is why we find the direct-to-consumer (D2C) movement interesting as it has major ramifications for hedge funds accessing the retail investment space. It is already getting a lot of focus in the US and Europe.
It will take time for hedge funds to realise the opportunities of D2C. It will involve investment either directly or via their service provider or via a fintech provider. D2C portals will need to be available to the end investor for not only trade processing but also enhanced reporting. The regulatory push for greater fee transparency and reporting is clearly driving this need. All investors, both institutional and retail, will expect and need full transparency into their holdings and improved reporting through easy to access, digitised formats. That’s where hedge funds managers may need to leverage an asset servicer like BNP Paribas’s Securities Services which has the resources and fund distribution experience, industry leading technology solutions and digital footprint to fully support our clients.
As hedge funds head down new routes of distribution and capital-raising, they must make sure that their operational capacity keeps pace. With strong collaboration across the industry and close partnerships, it will be an exciting time for all of us.
This article was first published by Funds Europe in February 2023 : Hedge funds explore the next big distribution opportunity (funds-europe.com)
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