EY: New Products Squeeze Hedge Fund Margins

Dec 4 2014 | 9:51am ET

Hedge fund managers are launching new products in an attempt to attract institutional investors, but such products are not necessarily great for the hedge funds' bottom lines.

That's one of the findings contained in Ernst & Young's 2014 Global Hedge Fund Investor Survey. EY contacted 100 hedge funds, representing $956 billion in combined assets under management, and 65 institutional investors, representing $1.3 trillion in assets ($220 billion allocated to hedge funds). Of the 65 investors polled, 14 were funds of funds and 51 pensions or endowments.

EY's findings are set against a backdrop of gradually slowing allocations to traditional hedge funds: in 2012, 20% of institutional investors surveyed expected to up their investments in hedge funds while in 2013 that percentage declined to 17%. In 2014, only 13% of surveyed investors planned to increase their allocation to traditional hedge funds in the next three years—the same percentage expected to decrease their allocation and 74% planned to leave theirs untouched.

In North America and Europe, investors planning to trim their hedge fund allocations outweighed those planning to increase them by about 25%, said EY. Among those investors who would like to increase or maintain allocations, 40% say they face obstacles such as allocating too much to a single asset class.

Said EY's Michael Serota:

“Given this backdrop, managers are trying to offer investors more flexibility on fees and tailored offerings via separately managed accounts and long-only funds. They are hoping to attract a new class of investor—private wealth platforms—as well as developing registered liquid alternatives products to try to attract new investors. The largest managers are even developing sub-advisory capabilities and insurance-related products.”

Innovation Has A Price

But there's a downside to this innovation: nearly one in four managers that launched a product in the last three years told EY it had had a negative impact on margins. How negative depended on the product: 43% of hedge funds said sub-advisory arrangements had had a negative impact on margins, 30% said registered products hurt their margins (including 45% of those who offer UCITS funds) and 24% said separately managed accounts hurt their margins.

EY's Fiona Carpenter called the negative impact on margins of new products “logical.”

“Separately managed accounts often come with fee concessions that impact margins and add complexity to reporting, sub-advisory relationships can carry unique reporting requirements and service provider demands, and registered liquid alternatives are lower fee products that require significant investment to set up. In fact, the negative impact on margins is most acute in Europe and among larger managers, both of whom have been at the forefront of product development in registered liquid alternatives. Without scalable operations, managers are likely to take a hit on margins when they launch new products.”

Regulatory Reporting

The survey also found that regulatory reporting expenses can translate into an added drag on margins, reaching 6% on average, assuming a historical margin of 30%.

Said EY's Natalie Deak:

“Regulatory reporting expenses, which were negligible even a couple of years ago, have grown significantly and are now impeding managers’ bottom line. For smaller managers it represents nearly a 7% drag and is creating a clear barrier to entry for new and emerging funds.”

Cybersecurity

A full 85% of managers surveyed said security concerns were the main impediment to using the cloud but while 80% intended to increase spending on cybersecurity, few had actually loosened the purse strings.

As for investors, fewer than one in three had confidence in their managers' cybersecurity policies.

Insufficient Planning

EY found that 46% of the largest managers surveyed (those with more than $10 billion under management) offer or plan to launch more registered funds, including UCITS, as a top priority; 32% are focusing on separately managed accounts; 14% offer or plan to launch sub-advisory capabilities; and 11% plan to launch insurance-related products.

Similarly, the top priorities for mid-size managers ($2-$10 billion) are separately managed accounts (28%) and registered funds (31%); whereas smaller funds (less than $2 billion) are most focused on developing their long-only offering (35%).

Said Serota:

“Our survey shows that managers who have not yet launched new products often underestimate the investment required to successfully bring a product to market and do not perform sufficient planning— this is particularly true for registered funds due to the increased operational complexity in reporting and compliance functions.”

Managers think that registered liquid alternative products require the most investment to set up (29% expect to have to make a very significant investment). More than half of managers say they are making the most significant investment in new technology to support their new products. Thirty percent of managers launching separately managed accounts are making the biggest investment in the front office, compared to 15% of those launching registered products. But 12% of those launching registered products are also making significant investment in the back office.

Smaller Funds Struggle To Fundraise

Larger managers point to challenges in developing infrastructure (29%) and hiring key personnel (25%). But when it comes to capital raising, just 8% of larger managers said this was a challenge compared to 33% of mid-size managers and 47% of smaller managers. In addition, the smallest managers also struggle with distribution channels, with a third naming this as the biggest challenge in adding new products or offerings.

Said EY's George Saffayeh:

“Investors consistently report that, when selecting a manager, they are most interested in the clarity of the investment philosophy and developing confidence in the management team. But there seems to be a mismatch between this and what managers think the decision is being based on, which is long-term and short-term investment performance. Given the increase of new products, it is more critical than ever that managers give investors confidence in their ability to generate future returns at appropriate risk levels rather than peddling past performance.”


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