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One of the next growth opportunities for the hedge fund industry may be the retail market, as investors increasingly seek out alternative asset classes. With analysts predicting that retail assets for the industry will climb to $940 billion over the next four years, from only $305 billion at the beginning of 2013, this represents a major opportunity for hedge funds, if they met these lofty expectations.

The Financial Times argues the trend is a convergence of traditional asset managers seeking out products with higher returns and hedge funds looking for additional capital. The demand from asset managers is a result of the struggle to offer alternative products to compete with low fee exchange traded funds (ETFs). While hedge funds certainly don’t offer lower fees than ETFs, they do offer strategies that can be marketed as unique and advantageous for investors. This is especially true in comparison to active equity or bond funds that as a whole haven’t been able to justify their fees in comparison to their ETF peers.

Mutual Fund Firms Snap Up Hedge Fund Managers while Retail Funds Launched

The mutual fund industry has been quick to move into the hedge fund space in order to establish a presence. Franklin Templeton was one mutual fund giant that was active in the hedge fund space, acquiring a majority position in K2. Legg Mason also was involved, adding Fauchier Partners to its group.

While these managers have been busy making acquisitions, hedge fund managers have been launching retail-oriented funds on a more frequent basis. Highbridge and AQR have recently released their own retail funds, while KKR has launched a fund to be distributed to retail clients by Charles Schwab. All of this stacks up to increasing pressure on the traditional mutual fund industry.

Shift in Fee Model May be Behind the Movement

One of the leading factors in the increased interest in retail hedge funds may come from how asset managers are compensated by their clients. Sandy Kaul, head of business advisory services for Citi Prime Finance, told the Financial Times, “In the US wealth adviser market there has been a shift in the pay structure, away from fee-based commissions over the past 10 years, and an increase in fees on assets under management.” As a result, wealth managers are looking to hedge funds to preserve asset value, and therefore, their fee revenue.

What are the Implications for Hedge Fund Job Seekers?

The potential for large scale retail acceptance of hedge funds is an important development for those currently in the industry or potentially seeking future opportunities. Many analysts have wondered where exactly future growth for the industry would come from, and in the past, retail investors would have seemed like a long shot. But recent regulatory changes and growing enthusiasm from money managers seems to be changing that belief. Retail hedge funds are increasingly viewed as a core component of future wealth management offerings. As a result, the increased growth potential of the industry should come as welcome news for those in the industry or considering a future in hedge funds.

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Those in the industry have come to appreciate the volatility in hedge fund investment, particularly the “moodiness” of investors. One month hedge funds are the answer to low fixed income yields, the next month they are an alternative investment class with potentially harmful tax consequences. While the core investors in hedge funds have remained committed, some investors do tend to run hot and cold with their hedge fund portfolio.

According to Reuters, in November the SS&C GlobeOp forward redemption indicator, which measures clients providing notice of withdrawal as a percentage of total asset, climbed to 5.19 percent, up from 3.19 in October. This marks the highest level of hedge fund redemptions since December 2009. About 10 percent of all hedge funds are administered by SS&C GlobeOp and form the basis of their data.

Potential Changes in U.S. Taxes Strike Fear in Investors

One of the current drivers of redemptions in the hedge fund industry is the ongoing concerns around tax issues. Uncertainty around U.S. tax policy moving forward following President Obama’s re-election has markets skittish. Mr. Obama has been vocal in his desire to tax wealthy individuals more aggressively, and many that have their personal assets tied up in U.S. based hedge funds may be considering a move offshore or to more tax efficient asset classes. Whether such tax changes materialize is unknown at this time, but once announced, it may be more difficult to make moves to avoid or minimize taxes, especially if some components are retroactive.

Fiscal Cliff cause a fall in Hedge Funds as well

In addition to the tax concerns, investors are seeing the upcoming fiscal cliff as a potential problem for hedge funds from a variety of angles. With a split Congress and leadership on both sides of the aisle that has not been willing to negotiate in the past, a permanent solution seems like a longshot, though there may be an intermediate resolution to push the issue out for several months. Nonetheless, the uncertainty is weighing heavily on all financial markets and hedge funds are not exempt. Most economists believe that if no agreement is reached by or soon after January 1st, the U.S. and global economies will suffer a significant setback. Broadly, hedge funds are not immune from macro changes in the global outlook, and returns will likely suffer at least to some extent in the event an agreement cannot be reached.

With that considered, market neutral or relative value strategies, for example, may actually outperform traditional asset classes in such an environment. That doesn’t necessarily mean that investors, especially institutional investors with squeamish plan members, will appreciate these nuances and hold through the cycle. Often pension plans and other institutional investors with fiduciary duties tend to stray from alternative asset classes during turbulent market conditions, such as those we’re seeing today.

While the remainder of this year looks to be uncertain and full of risk for the hedge fund industry, 2013 may pose some opportunity to the upside. SS&C does suggest that there is a great deal of capital on the sidelines, and a return to more stable fiscal policy in the United States and Europe may encourage additional risk taking. This bodes well for the hedge funds specifically and the financial industry as a whole.

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Hedge Funds see a Return of the Institutional Investor

November 5, 2012

Hedge funds have seen a significant change in their investor base in the last year as wealthy individual investors exit the asset class, according to a recent Reuters article, no longer seeing the same return potential in the lower risk strategies being executed by hedge funds today. The industry is beginning a transition back to its roots […]

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