Hedge fund managers are casting a jealous eye upon the lucrative retail market as institutional investors hammer hedge fund fee structures in the ongoing quest for improved value in their investments.

Small Pool—Vast Ocean

Hedge funds managers are beginning to face certain realities regarding the many issues with which they are challenged; increased regulatory pressures, unfavorable public perception, demanding institutional investors, and rising competition within the industry itself. As we know, assets under management have more than doubled in the past eight years, from $2.9 trillion in 2005 to almost $7 trillion in 2012. The number of  hedge funds increased dramatically during the same period, with more than 8,000 hedge funds in existence today.

The pool of institutional investors and the pool of funds they control have not grown in direct proportion to the hedge fund industry. As a result, increased competition for available funds has exerted a decidedly downward pressure on hedge fund fees and commissions.

As a consequence, the ever innovative hedge fund industry is turning its focus on the vast ocean of retail investors to whom retail alternative investments can be marketed.

New Opportunities Mean New Challenges

Hedge fund managers will encounter serious obstacles in the retail market. This is uncharted territory and, like other pioneers,they may find some arrows in their backs.

SEI Knowledge Partners recently published a white paper on this subject which identifies six key areas requiring focus.

1. Managers making the plunge into retail will need to create new marketing strategies, develop new platforms and add sales teams with retail experience. There are in excess of 300,000 financial advisers spanning a variety of sales channels creating a complex labyrinth, requiring extensive and thoughtful planning to navigate.

2. Some 48 percent of individual investors have little to no understanding of alternative investments and about two-thirds report that they would need to know more before investing. Hedge funds will need to develop education strategies to crack the retail market effectively.

3. Track records are an important metric for investors of all stripes. Clearly, there is a dearth of information available to potential investors because the alternative retail market is just beginning to blossom. This obstacle must be overcome.

4. Determining palatable strategies for the retail market is yet another hurdle for the hedge fund manager. Logically certain strategies may be more acceptable in the retail space than others. Finding this sweet spot will be a challenge. Liquidity restrictions and diversification options must be carefully considered.

5. Packaging the end product means determining the appropriate retail vehicle for the strategy chosen. This decision must comprehend not only the requirements but also the costs of short and long term distribution. Establishing a fee structure is another essential consideration in the process.

6. Structuring the retail fund will require the hedge fund manager to consider the investors being targeted, the distribution channels selected, the scope of operational support required and the costs of implementation. The hedge fund manager must also consider the role the fund will play; direct sponsor or sub-adviser. Finally, the manager must elect to launch either a stand-alone fund or participate in a shared trust structure. Forming a partnership with an experienced mutual fund service provider may assist in transitioning to retail.

Clearly, there are exhilarating days ahead and much at stake. McKinsey & Co., a respected consulting firm, predicts alternatives doubling their share of the U.S. mutual fund market and accounting for 25 percent of retail revenue by the close of 2015.

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