Super Bowl Ads for Hedge Funds? Not Yet, But Give It Time

It’s been six months since Securities and Exchange Commission voted to lift the 80-year-old ban on hedge fund advertising, yet no significant player has stepped forward to take advantage of the new latitude in the rules. That’s prompted some industry observers to dismiss the lifting of the ad ban as so much hype, with little consequence for industry.

Perhaps, though there’s reason to believe 2014 could see at least a couple of hedge fund providers develop an advertising strategy to expand their dialogue with investors in innovative ways. And, advertising aside, the new rules give private funds more leeway to share information with the financial media, post information on their web sites and engage in more detailed conversations at conferences.

But two things have to happen before private funds take full advantage of the changes in general solicitation rules. First, fund executives and their legal advisors will need to see a more defined, stable and coordinated regulatory environment. Second, before writing any checks for advertising campaigns, marketers of private funds have to figure out a campaign approach that aligns well with their targeted client base, business model and marketing resources.

Regulatory Risk

In the meantime, few hedge funds feel comfortable being out front in what feels these days like a transitional – and therefore risky – regulatory environment. SEC followers believe the agency may have additional guidance on marketing rules down the road, so funds are not in a rush to test the current ones. Some of that guidance may spell out steps private funds must take to verify accredited investors.

Also weighing on hedge funds is the lack of coordination among the regulators. Many hedge funds use derivatives, bringing their operations within the purview of the CFTC. But the CFTC has been slow to bring its rules restricting advertising into line with the SEC changes. Hedge funds and their advisors hope that the issue will come high on the agenda of Timothy Massad, who looks to be on a clear path for Senate confirmation as the new CFTC chairman.

A further complication: Some hedge fund advisors have yet to go through their first full annual examination cycle following their required registration with the SEC. There’s little appetite for taking any action that might complicate those reviews.

Then there’s industry politics. It’s worth recalling that SEC was pushed into liberalizing the rules by congressional passage of the so-called JOBS Acts, which directed the agency to lift some constraints around advertising and solicitation in securities offerings. Those changes were resisted vigorously by the mutual fund industry and consumer organizations, which are seen as likely to pounce on any marketing misstep by a hedge fund.

The Scale Question

Should more clarity around rules develop, at least a couple of significant hedge funds may be tempted to consider advertising. That’s because the industry, coming off a pretty good year in terms of asset flows and performance, looks set for further growth in 2014. HFR estimates that net inflows into hedge funds totaled $63.7 billion in 2013, and total capital grew by $376 billion, the biggest increase in three years.

In that environment, 2014 is expected to bring a significant crop of new funds. Some successful managers have closed funds and are looking to seed new ones. And talented traders who abandoned the big banks in the wake of the Volcker Rule clampdown are finding backers.

New funds will look for ways to grow assets quickly, an imperative given the more demanding economics of the industry and the intense competitive scene. Much of the pressure for fast growth flows from the higher costs of regulatory compliance. By some estimates, regulatory compliance costs can run as much as $700,000 annually for smaller hedge funds. That level of cost drag can be deadly for slow-growing entrants.

Moreover, demonstrating a strong compliance and operational structure is critical to attracting assets in the post-Madoff world. That’s one reason that institutional investors tend to favor larger funds with significant assets and resources. Based on HFR figures, nearly two-third of net flows in 2013 went to funds with more than $5 billion of assets.

What role can advertising play in this competitive scramble for assets? The traditional view of the industry suggests a limited one. As widely noted when the rules were relaxed, secretiveness and exclusivity have been part of the allure of hedge funds. One hedge fund executive dismissed advertising as a “sign of desperation” – a potential turn-off to both wealthy individuals and the institutional market.

Another disincentive for smaller hedge funds is simply cost. Ad campaigns – even in professionally focused media – can be expensive relative to the revenue opportunity, and results can be hard to measure.

‘Institutional Quality’

The institutional market holds special challenges, given the changes over the last five years or so. Pension funds and their consultants, family offices, foundations and endowments, and corporate treasurers increasingly value predictability, risk management and transparency. They look to hedge funds to bring significant intellectual capital to the relationship to help meet specific strategic targets.

Hedge funds that have reached a significant level of assets and have marketable track records may find advertising useful in their marketing mix to establish and reinforce a reputation for “institutional quality”, particularly in positioning themselves against the largest players.

This approach fits well with content-driven, “thought leadership” campaigns. The embrace of “native advertising” – essentially sponsored editorial content structured in “share-able” ways − may offer cost-effective, measurable solutions for such campaigns, as the growing number of digital publications compete more intensely for ad dollars.

Sizing Up the RIA Market

One target audience has generated much discussion in the hedge fund industry – the 10,000 or so independent Registered Investment Advisors (RIAs) who serve individuals and families. The RIA category represents a complex, diverse audience, ranging from shops with a handful of advisors to substantial networks with scores of professionals.

The scale of the RIA market and the assets it commands make it an attractive audience for brand building. Independent RIAs control over $1.15 trillion of long-term mutual fund and ETF assets, according to a 2013 estimate by Access Data, a Broadridge Financial Solutions company. Last year’s survey by suggests that RIAs allocate about 5.5% of their assets under management to hedge funds, managed futures, and commodities, with 41% of respondents saying they planned to increase their alternatives allocation.

But the RIA market is a mixed picture for hedge funds. Registered versions of familiar hedge fund strategies – known as “liquid alternatives” – have already had substantial success with the RIA market. RIAs like the familiar ‘40 Act structure of “liquid alts.” Demand from independent advisors helped drive liquid alt net inflows of $88 billion in the first 11 months of 2013, according to Morningstar data. By some estimates, RIAs’ client holdings may account for 15-20% of the total AUM of liquid alts products.

The potential good news for private funds is that the relaxed marketing rules give them more leeway to provide performance and other details, allowing them to compete with registered liquid alternatives on more equal basis. In effect, the JOBS Act is another step in narrowing of marketing and disclosure differences in the rules for registered funds and private funds. It also creates an opportunity for larger asset management firms to add private funds to their stable of “liquid alts.”

But private funds still face a range of complications in competing with liquid alts for RIA assets. Fees stand out as one of the big challenges. Liquid alts’ expense ratios average about 177 basis points, according to Morningstar. That’s about 50 basis points higher than the average actively managed registered mutual fund, but far below the pricing that private hedge funds typically seek.

A more prosaic complication is tax reporting. Some RIA clients recoil at having to deal with the K-1 forms that come with limited partnerships.

It’s also worth noting that RIAs themselves are under regulatory pressure that weighs on their demand for alternatives. On Jan. 28, the SEC issued a “risk alert” to financial advisors, cautioning them to conduct appropriate levels of due diligence before allocating client funds to hedge funds and other alternatives. The Commission said its recent examinations had turned up cases in which advisers had come up short in meeting their fiduciary obligations to make sure that these investments were in the best interest of their clients.

Intensified regulatory scrutiny quickly translates into a more demands from RIAs on alternatives managers for transparency, updates and customer support in general. As hedge funds seek to broaden their appeal through advertising and other marketing channels, they will need to make sure they have resources and processes in place to address the customer service challenge that comes with a more diverse investor base.

Bill McBride
January 30, 2014

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