Boutiques and active long-only fund managers could win the ‘battle for allocations’ in 2021
By Gary Clifford-Newman, Vice President, Prime Services Sales at London-headquartered brokerage Sova Capital. Clifford-Newman joined Sova Capital in 2018 and focuses on delivering prime services for hedge funds and managers accounts covering equities, fixed income, futures and options execution, prime-financing and custody solutions.
In response to market volatility driven by the pandemic and the UK’s departure from the European Union, investment allocations that were previously – and cautiously – withdrawn from hedge funds will require a new home. Fund managers aiming to attract those allocations must carefully balance their fee strategies and service levels while accounting for several key market trends: greater downward pressure on fees, rising opportunities for small to medium funds, counterparty consolidation, and rising interest in long-only strategies.
The legacy ‘2 and 20’ fee arrangement has been scrutinised for years - arguably since the financial crisis of 2008 – and managers have responded to this downward pressure on fees with various solutions, including performance hurdle rates, reducing the management and performance fee components, and performance-only fee strategies. Each solution presents both advantages and disadvantages to both fund managers and investors, and one option does not fit every situation.
Regardless, institutional investors appear likely to continue to exert downward pressure on fees, demanding deep discounts on both the management and upward performance fees in return for allocations. This trend will significantly impact the operational viability of any fund, and managers should pay close attention to break-even points and viability in terms of long-term operating capital.
Focus on those factors is particularly important in 2021, when it is likely an abundance of new funds will enter the market, driven by portfolio manager spinouts, launches of new fund concepts, and fresh strategies from existing managers. These recent entrants will intensify the battle for allocations, and managers must fine-tune their negotiating strategies to ensure they secure those vital early-stage allocations.
Given the highly saturated nature of the hedge fund industry, managers of small (sub-USD 100 million) to mid-sized funds (USD100 million to USD1 billion) possess a key advantage. Boutique funds are nimble, able to attract institutional allocations by offering discounts and flexibility on fees that are out of reach for larger, encumbered funds. Post-pandemic, it would be reasonable to expect smaller funds to be increasingly innovative, for instance, using an arrangement where investors pay a lower performance fee in return for committing capital to the manager for a guaranteed period of time.
Counterparty consolidation provides another opportunity for boutique providers. Fund managers have taken some hard hits over the past year, as Brexit fatigue, the US election and Covid-19 created a convergence of market volatility and stretched collateral levels which in some cases led to margin calls, a spread-out workforce, technology pressures from both old and new platforms and investor uncertainty.
These factors drove rising investor demand to work with service partners capable of providing high levels of service to support their clients from trading, operational, technology, and reporting perspectives. Service providers able to meet these rising expectations in terms of availability, expertise and capability earned client loyalty; however, the reverse also applies – any aspect of service level that has fallen below client expectations results in shifting loyalties.
Already, we’ve observed the announcement of a number of service provider RFPs for key functions such as administration, execution, prime and custody services. This creates opportunity for specialist boutique providers to step into this space, and it is likely that mandates will be awarded not only based on price, but on service level assurances, product/market coverage and ability to efficiently provide multiple services in one seamless product suite from the perspective of the client.
In the coming year, as they consider whether the returns produced by alternatives managers justify those managers’ fees, investors are likely to be drawn to long-only, actively managed funds. This strategy is trending as a result of stocks that are fundamentally undervalued versus their intrinsic value as a result of price corrections in response to the pandemic and other macro and geopolitical factors.
Additional potential price corrections, resulting from shifts in market sentiment following the (eventual) economic recovery from Covid-19, could lead to high quality returns for long-only fund strategies, and investors will take notice.
This trend overlaps with another – downward pressure on pricing – as long-only strategies tend to attract lower fee levels given their potential for significant AuM growth over time. Additionally, long-only strategies currently provide an avenue to generate returns while maintaining liquidity, as managers are seeking opportunities to generate strong risk-weighted returns in a liquid asset class.
Of course, it is still early in the year and difficult to predict the geopolitical or macro factors that will drive the markets through 2021. That said, fund managers mindful of these current trends as they develop their strategies with an eye on striking that ideal balance of fees and service may discover opportunities now while they plan for what’s to come.