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The 10th annual survey found that hedge fund growth has slowed for a variety of reasons – the abundance of low fee passive investment options, lackluster hedge fund performance and cost concerns. In 2016, the proportion of North American investors that said they were reducing allocations to hedge funds exceeded the proportion that were increasing for the first time since the financial crisis of 2008.

Investors have more options than ever within the alternatives marketplace and are allocating funds to those managers that have a unique offering that is satisfying a specific need. Therefore, hedge fund managers must be at the forefront of actively listening to their investors to keep pace, or else be left behind, the report finds.

Michael Serota, EY Global Leader, Hedge Fund Services, says, "Growth is the industry's top priority, but managers are changing the strategies employed to achieve it. While we find the largest managers pursuing several growth strategies, the smaller managers are more narrowly focused, seeking to expand investor bases within their home markets. Amidst today's challenging environment, it is imperative for managers of all sizes to identify the needs of their clients and align product offerings to their demands."

Hedge fund managers focus on asset growth to counter reduced inflows

More than half (56%) of managers say asset growth is their first priority, but they are also facing an unprecedented change in investor appetite that can affect growth strategies. Almost half (48%) of investors expect their hedge fund investments to shift from traditional hedge funds to other alternatives over the next three to five years, while 42% expect to shift from co-mingled hedge funds to customized vehicles and segregated accounts.

However, some managers are falling behind on investor demand for products. Although investors have a broad appetite for real assets (63% invested), private equity (59% invested), long only funds (56% invested) and best ideas funds (51% invested), only a small percentage of hedge funds currently or plan to offer these products.

The largest managers have the momentum to attract capital, as one in three of the largest managers offer private equity, real asset strategies and best idea vehicles, compared to single- digit percentages for smaller managers. Mid-size and smaller managers do anticipate catching up as 33% of mid-sized managers and 48% of small hedge managers see their firms offering some non-traditional hedge fund products in three to five years.

Managers of all sizes are viewing next generational technology and data as a means to enhance their investment program and attract investors. More than half (52%) of managers use non-traditional or next-generation data and big data analytics to support their investment process, or plan to do so in the next two to three years. The smallest managers are the most active, with 59% indicating that they use this technology.

Natalie Deak Jaros, EY Americas Co-Leader, Hedge Fund Services, says: "We are seeing assets flowing to the managers that offer a wide array of non-traditional hedge fund products. Managers that do not respond to changing preferences must ensure they offer something unique to potential investors."

As fee pressures increase, managers need to innovate and optimize processes to cut costs

Hedge fund managers' average operating expense ratio is down from last year, but investors feel there is still room for improvement. Lack of performance, the plethora of lower cost alternatives and investors' increased comfort in trading on their own behalf is causing them to challenge fee terms with their managers.

Including management fee, the expense ratio is down from 1.95% in 2015 to 1.84% in 2016 as investors continue to apply pressure. The declines in management fees are driving this trend as average reported fees for 2016 were 1.35%, down from 1.45% in 2015. Despite this downward trend, only 20% of investors are currently satisfied with the expense ratios of their funds.

Managers have achieved significant operational cost reductions, but agree opportunities for further efficiencies exist. Nearly half of managers (44%) reported actual or expected cost reductions in the middle and back office. Investors are comfortable with outsourcing to further reduce costs, but managers aren't giving up control of certain functions. Almost 80% of investors approve of outsourcing middle office functions, but only 18% of managers currently outsource middle office or plan to do so. Additionally, in the back and middle office, robotics and other automation are creating efficiencies and driving savings necessary to counteract margin compression.

Prime brokerages are putting pressure on hedge funds to evolve their relationships

Regulations enacted post-financial crisis continue to filter through the banking industry and impact how prime brokers service the hedge fund industry. Prime brokers are requiring managers to alter their relationships, which impacts how funds conduct their core trading and financing processes. Almost 60% of managers say their prime brokers have requested fundamental alterations to their relationship to keep it economically viable.

Prime brokers continually re-evaluate the types of managers they are willing to do business with, and managers have responded by engaging with an increased number of prime brokers, as managers reported to use an average of 3.9 prime brokers.

Graeme McKenzie, EY Asia-Pacific Leader, Wealth & Asset Management, says: "Managers and their counterparties continue the dialogue as to how to best partner together in light of funding, balance sheet and liquidity considerations. The landscape has become significantly more challenging as managers increase the number of financing relationships while each individual relationship is becoming more complex to manage."

Managers are focused on developing their talent management programs, which investors see as increasingly important

Investors increasingly request details on hedge funds' talent management programs, as 75% of investors indicated they make this request and use it as a key consideration in their due diligence.

Although 52% of managers are confident that client loyalty is rooted in strong relationships between the firm's founding principals, 55% of investors state their primary allegiance is to their portfolio managers. To bridge this disconnect between perception and reality, talent management programs are evolving as managers focus on attracting and retaining talent.

Zeynep Meric-Smith, EY EMEIA Leader, Hedge Fund Services, says: "Managers should ensure their talent program is appropriate to grow and retain talented investment professionals and succession plans for their portfolio managers. Investors should be confident in the institution's ability to generate returns if a 'star' leaves. Secure talent that will drive the business forward in the future and achieve maximum growth."

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