Increasing costs and downward pressure on fees creating the perfect storm for hedge fund industry

(As originally published in FEI Canada F.A.R. member e-newsletter, February 2013)

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By Joseph Micallef, Financial Services Partner and Canadian Asset Management Industry Tax Leader, Ernst & Young LLP

Ernst & Young’s most recent annual Global hedge fund and investor survey — the goal of which is to record the views and opinions of hedge funds and hedge fund investors globally, measure the views of each on the same topics and examine the two groups together — finds nearly 60% of hedge fund managers in North America say the cost of business has increased in the past year. However, it also finds there continues to be a disparity between managers’ and investors’ views about what costs should be borne by the fund.

Sixty-eight percent of funds reported that they pass along these increased costs — which is up from only 34% in 2011. And, there will continue to be a greater push and pull on this issue of cost allocation for the foreseeable future as investors increasingly show less appetite for costs to be charged to the fund than they did a year ago. We don’t see this trend changing unless funds greatly improve investment performance returns.

Our survey also finds that while investors certainly consider a fund’s performance when deciding whether to invest or discontinue their investment with a particular fund, it’s not — contrary to what most fund managers believe — their top consideration.

Long-term performance is only the fourth most important criteria for investors, after the investment team (82%), risk management policies (70%) and clarity of investment philosophy (66%). And compared to 2011, both long-term and short-term past performance declined in importance for the investor community.

Although investors clearly look at past performance, confidence in the people who will generate future returns is more important, and confidence in the processes that will appropriately manage risk-taking is at least equally important. Transparency continues to be important to investors; leading hedge funds have shown that transparency means more than reporting on holdings and performance and now differentiate themselves from peers by communicating proactively and providing high levels of access to key personnel during due diligence.

The survey finds 84% of investors are inclined to take their assets elsewhere when there are changes in key personnel. This shows that the industry remains largely a people business, and turnover is a communication issue for funds. But managers who communicate openly and honestly with investors about changes in the team and performance issues give investors more confidence about their future returns, which is critical to keeping them from pulling out of the fund.

In December, we brought together managers and investors alike at Ernst & Young’s Global Hedge Fund Symposium in Toronto. At the symposium, we discussed the survey results, as well as other issues, including hedge funds having to make increased investments in headcount and technology in order to meet increasing regulatory burden and prepare for expected growth. This, despite the fact that survey results indicate only 10% of investors feel that regulations effectively protect their interests, and 85% of investors do not believe more regulation will effectively prevent another crisis.

The general increase in costs, including regulatory-related expenses, has created more barriers to entry for start-ups in the industry, and we’re seeing consolidation among those that don’t yet have capital to support investment in new infrastructure.

However, investor support for emerging and start-up funds is increasing. Investors are allocating more to small and new managers, and funds of funds are demanding — and getting — concessions, particularly on fees. But investors and managers are drifting further apart on aligning compensation with risk and performance. This gap between managers and investors on compensation structures is not new, but the fact that it shows no sign of narrowing may become troublesome. In 2010, 94% of managers felt risk and performance were effectively aligned with investor objectives, while 50% of investors felt the same; in 2012, 87% of managers feel this is true, while only 42% of investors agree.

The overarching theme we’re seeing is — with the cost of doing business increasing, and investors not ready to foot the bill — conditions are ripe for a perfect storm. But, while this storm is likely to persist in the short term, there are still investments to be found. Managers who are creative about where they seek these untapped investment capital dollars will thrive.

To read Global hedge fund and investor survey 2012: finding common ground, click here.