Operational opportunities to reduce hedge fund expenses

Date: Wednesday, May 8, 2013
Author: Samer Ojjeh and Natalie Deak Jaros, Pensions&Investments

As the hedge fund industry has grown, so has the cost of running a fund complex. The upsurge in expenses has hastened in recent years, as firms have begun to invest in new technology and additional staff to deal with the issues of a quickly changing landscape. Regulations and investor needs have been the primary forces driving the cost increases.

Nearly half of those interviewed for Ernst & Young's sixth annual Global Hedge Fund Survey said that their expenses had increased in the past year. In North America, 60% of respondents reported increased costs. According to the survey report, “Finding Common Ground — Global Hedge Fund and Investor Survey 2012,” the firms that reported higher expenses saw average increases of 15%.

Many firms are choosing to redesign aspects of their operating models, hire additional staff and invest in new infrastructure as investors and regulators are demanding more consistent, granular and timely data. Investors want information that will allow them to monitor fund performance, track observance of investment guidelines and manage portfolio risk.

Meanwhile, regulators now have greater authority to collect data under the Dodd-Frank Wall Street Reform and Consumer Protection Act. For example, most hedge fund managers are now required to register as registered investment advisers. Thus, they need to file the newly expanded Form ADV and the complex Form PF. These forms demand precise data about asset values and risks.

Many hedge funds have not reacted to these demands in a structured and strategic way to create long-term solutions. According to our survey, roughly 45% of hedge funds are adding headcount in support functions — middle office, back office, risk management and legal and compliance — in order to manage growth, client requests for more information and the increased regulatory demands.

While the largest funds are indeed investing in technology and seeking to outsource more functions, a bigger percentage are adding staff in the middle and back offices. This implies that a large proportion of hedge funds is still working at less-than-peak efficiency, under-utilizing technology and outsourcing options.

The larger funds may lack the motivation to address this problem because of the economies of scale they enjoy. For example, firms with $1 billion to $5 billion in assets under management have on average eight full-time employees per $1 billion of AUM. Those with more than $10 billion have fewer than five on average.

However, it is clear that the vast majority of funds will continue to grow and expand into new strategies. Thus, it is vital that they build scalable operating models to support such growth as efficiently as possible. The components of such a model include changing their approach to three areas:

The use of fund administrators
The approach to administrator shadowing
The use of technology

Relationships with administrators

Fund administrators have invested a great deal in infrastructure in recent years that enables them to offer a larger menu of services to their clients. Cost pressures have prompted fund managers to explore the value of these additional services, and to ask for more capabilities from their administrators.

The problem is most hedge fund managers do not see much scope for further outsourcing. Seventy percent of survey respondents do not plan to increase their outsourcing in the next two years. However, given the increased cost of doing business, and the pressure on fees charged by the funds, managers may want to re-evaluate opportunities to outsource, as outsourcing providers continue to develop their service offerings and demonstrate track records — particularly around operations and middle-office functions.

The hedge fund managers who do plan to expand their outsourcing in the next two years listed middle office (16%) and back office (13%) as the top areas they are considering. Risk management came in last, at 4%, which is not surprising considering the majority of investors who responded to the survey noted that it would be unacceptable for their hedge funds to outsource front-office or risk-management activities.

Changes to administrator shadowing

The hedge fund industry's practice of shadowing its fund administrators is unique and extremely costly. Nearly 90% of the hedge fund managers in our survey shadow at least some functions, a marginal increase from 84% last year.

One in four said that they had increased the amount of shadowing they do. As fund managers grow and expand into new strategies, the volume of processing and accounting they shadow increases.

Investors may gain confidence from fund managers' shadowing, but only about half of investors say they are willing to bear the cost.

In light of the greater focus on fund expenses, and the shrinking margins of most managers, the industry will need to coalesce around a shadowing standard that is both cost effective and within a reasonable risk tolerance.

Funds should consider moving from a full shadowing approach to one where they “review” their administrator's work. Fund managers are challenged to build an efficient control environment which would take advantage of the administrator's strengths while building compensating controls to address the administrator's shortcomings. By establishing a thoughtful risk-based approach that combines a review function with partial shadowing, hedge funds would recognize the cost efficiencies of using an outside administrator while providing both managers and investors with confidence in the areas outsourced.

Use of technology

Technology is a large expense, and implementing it on an ad-hoc basis can lead to costly inefficiencies. There are some basic steps fund managers should take to rein in these costs.

First, fund managers should think about the criteria and processes for selecting technology. The challenge is to find technology that will minimize the use of multiple, incompatible platforms, and the duplication of data purchases and processing.
Second, fund managers should rationalize their use of current technology. Not every piece of technology needs to be replaced. However, it is vital that all systems are current and being utilized to their full capacity.
Third, fund managers should establish effective governance over the utilization of data. Many funds have various vendors and warehouses to manage the same sets of data, which are used by different groups inside the organization. By assigning responsibility to the middle office to manage the gathering of data from vendors and the distribution of it to users, fund managers can reduce redundancies and inefficiencies.
Finally, fund managers should explore systems that automate repetitive tasks that are now performed manually. For example, software can help automate 50 to 70% of the work needed for regulatory compliance.

While finding the time for strategic operational planning is difficult with the myriad business, investor and regulatory demands that fund managers face today, it is crucial. The sooner such planning can take place, the sooner the benefits of these cost control measures can be enjoyed.

Samer Ojjeh is a principal and Natalie Deak Jaros is a partner in the financial services office of Ernst & Young LLP, based in New York.