The Future of Funds – Part 1

Canary_Wharf_at_night_from_Shadwell_cropped-1024x716 The Future of Funds - Part 1

London – Source: Wikipedia

Future of Funds

As the finance industry is still recovering from a massive crisis and change together with an erosion of trust the alternative investment and funds industry is going through a spot moment. The Fund industry is indeed going through a massive disruption and change. In this two-part article, essay we will discuss some of the key topics that are trading in the funds, alternative investment, hedge funds and other related players industry, and we shall be taking a detailed look at the issues under discussion by professionals and thought leaders alike.

Future of Funds – Technology: Trading platforms, connectivity, and multi-asset class liquidity solutions

  • Trading Platforms

Perhaps the biggest change that online trading technology has brought about is to democratise access to the markets, allowing individuals to make their own trades without the costs and time lag that were associated with the old way of doing this – namely contacting your stock broker. This has been accompanied by other changes intended to make the markets more accessible to individual investors, such as mini and micro-lot trading, leverage, and online training courses.

This has presented a challenge to the funds industry, in that investors now have the option of placing their own trades rather than trusting in the performance of professional investors – a trust that has been eroded somewhat in the wake of the financial crisis of 2008.

Also, the social trading model, in which investors can follow and/or copy the trades of professional traders using their own trading account, has presented a half-way house alternative to fund investment that incorporates some of the involvement and freedom associated with online trading with the opportunity to leverage the skills and knowledge of successful traders. Because you can see every move the trader makes, there is a lot more transparency associated with the social trading model than with the fund investment model, in which trades are largely kept secret and you only find out how well your investment has performed at quarterly or annual intervals.

That being said, the online trading revolution has also opened up a lot of opportunities for the fund industry, particularly in terms of training and recruitment. With online trading platforms being available to anyone with an internet connection, the talent pool for new traders has been widened considerably, and most rookie traders have spent years cutting their teeth on retail trading platforms before embarking on a career in the investment industry.

  • Connectivity and Multi-Asset Class Liquidity Solutions

Initially, most retail-level online trading platforms were restricted to foreign exchange (forex) and binary options trading. However, in recent years, this range has been expanded to include the full spectrum of asset classes, including equities, commodities, and futures.

The rapid evolution of trading platforms has also provided new technologies for professional traders, too, and this process has also provided new alternatives in terms of liquidity solutions and ways to connect with the markets – in particular, high-end protocols such as DMA (Direct Market Access) and STP (Straight Through Processing).

There are advantages and disadvantages to each type of broker model for accessing the markets, with some being more suited to different trading styles or investment models than others. For example, high-frequency trading techniques, as used by funds that employ quantitative computer-based trading strategies, are heavily reliant on fast connections and low or no-slippage execution, such as that provided by DMA brokers.

Topic: What the future holds for the investment sector

In the years following the financial crash of 2008, there have been two trends that have been predominant in discussions of the investment sector: regulation, and the influx of institutional money into the hedge fund industry.

  • Regulation

Although there have been many explanations given for the financial crisis of 2008, much of the blame was laid at the door of the financial services sector, and there is no doubting that a more responsible attitude towards risk-taking could at least have prevented the collapse of major investment banks such as Lehman Brothers. With the taxpayer ultimately footing the bill to bail out the banking system – resulting in massive and often unmanageable sovereign debt increases – there was acute political pressure to ensure that such a set of circumstances could not happen again, and also for the financial sector to play major part in rectifying the situation.

One of the most important pieces of regulation that resulted from this was the Dodd-Frank Act, which places restrictions on certain trading activities and requires a much higher level of disclosure from investment firms such as hedge funds. This, along with ailing markets, has put a squeeze on the returns that fund managers have been able to deliver for their investors. In 2013, only a handful of elite hedge funds managed to outperform the S&P 500, with many of the biggest names – including Ray Dalio’s  Bridgewater Associates, the biggest hedge fund in the world with over $80bn under management – doing significantly less well than the market.

These less-than-impressive returns are often justified on the basis that they are risk-adjusted, and that the returns from most managed funds have at least been, at the very least, much more consistent than those of the raw market indices. However, this does not mean they are immune to losses, and the majority of hedge funds made losses in 2008 and again in 2011.

With governments ending up heavily in debt after the bank bailouts, the need to raise money through taxation has also become more acute. For over a century now, corporations and high-net-worth individuals have avoided what they might see as Robin Hood-style taxation by making investments via banks and funds based in low-tax countries such as Switzerland and Lichtenstein, or offshore jurisdictions such as the Cayman Islands.

With such arrangements offering a clear advantage over onshore investments, it has become the norm for wealth managers to use these to maximise returns for their investors, but in the wake of the financial crisis, political pressure to close these tax loopholes has become much stronger, and legislators have acted accordingly.

This has resulted in legislative efforts to clamp down on tax avoidance, resulting in a huge overhaul of the regulations surrounding overseas and offshore investments, particularly the US’ FATCA regulations, which have recently undergone major revisions with multilateral support. While the regulations do not quite spell the end of tax havens, they certainly redraw the map regarding the taxation arrangements related to alternative investments, and present fresh challenges to an industry that has, in the past, benefited greatly from the banking secrecy laws that exist in certain jurisdictions.

  • Institutional money moving to hedge funds

Another effect of the squeeze on the money management industry is that the heavily-regulated mutual fund model has lost ground to hedge funds in the scramble for money from major institutional investors such as pension funds. While traditional long-only buy-and-hold investment strategies that are commonly employed by mutual funds can still be effective, in recent years their reputation for being less risky than hedge funds and other alternative investment vehicles, which can use a variety of financial derivatives to make money from falling as well as rising asset prices, has been tarnished considerably. Even if a fund makes money, by the time fees and taxes have been deducted, they can often end up with net returns that fail to beat inflation or even make a loss.

As a result, institutional money that previously poured almost exclusively into mutual funds – seen as less risky – has been increasingly diverted into hedge funds and other alternative investments, which have been proven over time to be more effective in generating risk-adjusted returns. This trend has been exacerbated by the talent drain from the mutual fund industry into hedge funds, which allow traders more freedom to make the market moves they need to make to turn a profit by dint of lower regulatory burdens and a less restrictive business model.

However, this influx of institutional money has not been welcomed across the board by the alternative investment industry. The greater demands for disclosure required for dealing with this part of the financial service sector has placed greater administrative burdens on hedge funds, biting into profit margins and restricting the range of trading activities that they can pursue.

Canary_Wharf_at_night_from_Shadwell_cropped-1024x716 The Future of Funds - Part 1

Toronto – Source: Wikipedia

Also, there would seem to be a tipping point at which high levels of capital can hinder a fund management firm’s returns, and there has been a trend recently of firms returning capital to investors in an effort to stay nimble and keep posting high profit percentages. It’s telling that in the last few years small and mid-size hedge funds have been the ones topping the charts in terms of returns, while the biggest ones have been struggling to maintain their performance levels with higher levels of capital under management.

In a next article, we shall be continuing our guide to the issues under discussion at the Future of Funds with a look at how technology and social media are disrupting and opening new opportunities for hedge funds, as well as the benefits of outsourcing back-office administration to third parties.

This article is associated with the Event The Future of Funds. This Thursday 5th June 2014, Saxo Capital Markets and JP Funds Group will be holding an event entitled “The Future of Funds – Technology and Innovation” at the London Capital Club. It kicks off at 5pm with a drinks reception, followed by an introduction from Saxo Capital Markets CEO Torben Kaaber, and ends at 7pm – registration instructions are at the base of this article.

The event will feature talks from prominent thought leaders from within the investment industry, including Torben Kaaber and Richard Elston from Saxo Capital Markets, Janet Thomas from Infinity Capital Partners, Dinis Guarda from Ztudium – HedgeThink.com – Intelligenthq.com, and Julian Stockley-Smith from JP Funds Group.

If you’re interested in attending the event, please confirm your attendance with Uriel Alvarado ual@saxomarkets.com.