Hedge fund managers in Europe need to focus on building closer partnerships with investors by providing additional services, according to the latest issue of The Cerulli Edge―Global Edition.

Hedge fund managers have institutionalized their offerings in the past decade, but based on a survey by Cerulli Associates, there is a recognition of the importance of establishing strong ties with investors. More than half (58%) of the managers Cerulli surveyed said that focusing on partnerships will be a very important priority over the next 24 months when distributing their hedge fund strategies.

“Although providing additional services will be challenging for smaller managers, mid-sized and larger managers should aim to build holistic partnerships with their clients; this can improve investor retention even during downturns in performance,” says Justina Deveikyte, director in Cerulli’s European institutional research team.

Such partnerships typically feature reporting capabilities (including environmental, social, and governance, or ESG, metrics), exposure to investment teams, and digital content. In addition, although transparency has improved, managers will need to make further progress as investors demand more position-level exposure data, including ESG metrics at the security and fund levels. This demand is expected to stem predominantly from European institutions rather than private banks or family offices.

Although Cerulli’s research indicates that European investor interest in hedge funds is set to increase, to create fundraising opportunities, managers will need to increase their competence in responsible investing, improve their client servicing, and focus their product development initiatives on unique and capacity-constrained propositions. Sustainability-oriented hedge funds, including liquid alternatives, are expected to become more dominant in the market as institutional investors expand their responsible investment policies to cover the whole of their portfolios. Cerulli’s survey found that 73% of hedge fund manager respondents prioritize incorporating ESG considerations into the investment process. However, the assets under management (AUM) of dedicated ESG liquid alternative funds remain low, representing only 2% of total industry AUM. Nearly two-thirds (60%) of the hedge fund managers Cerulli surveyed see the incorporation of ESG factors as a competitive advantage.

“Although dedicated ESG liquid alternative fund AUM remains limited, representing only 2% of total industry AUM, Cerulli anticipates growth. We expect managers’ negative screening approaches to gain most traction,” says Deveikyte.

One niche area that is experiencing growth is hedge fund replication and passive benchmark-tracking strategies that aim to provide a more passive exposure to an underlying hedge fund benchmark. Although the demand for such strategies remains low, growth is likely. Investors can use these products as a bridge while changing or investing in new traditional hedge fund strategies, or as a cheaper alternative to traditional hedge fund exposure.

Other Findings:

• In Southeast Asia, asset owners are considering alternative and foreign investments to achieve their target returns in the low-interest-rate environment. However, some institutional investors have concerns, including the liquidity risks that come with investing in private markets. Also, institutions would have to enhance their risk controls when expanding into new asset classes. Asset managers can play a role in helping asset owners meet their target returns and manage liquidity risks.

• Cerulli believes that the adoption of liquid alternative products in the U.S. is being significantly hampered by three key factors: high costs, performance chasing, and the complexity of exposures. Firms distributing such products should focus on education highlighting the importance of advisors holding positions through drawdowns. Products need to be positioned using a simplified approach in which advisors are able to effectively evaluate the success of the investments.