An EY survey finds hedge funds cutting where they can to meet investors demands for new vehicles and lower fees.
Hedge fund managers report that they have achieved “significant operational cost reductions,” even though they are looking toward additional opportunities for efficiency, according to an EY survey of firms that also finds funds under pressure from investors armed with new demands.
The EY report, “Will adapting to today’s evolving demands help you stand out tomorrow?” is based upon EY’s tenth annual 2016 Global Hedge Fund and Investor Survey.
In the report, “nearly half of managers (44%) reported actual or expected cost reductions in the middle and back office,” according to EY. “Investors are comfortable with outsourcing to further reduce costs, but managers aren’t giving up control of certain functions.”
The report finds that nearly 80 percent of investors “approve of outsourcing middle office functions, but only 18 percent of managers currently outsource middle office or plan to do so. Additionally, in the back and middle office, robotics and other automation are creating efficiencies and driving savings necessary to counteract margin compression.”
While hedge funds are struggling with operational efficiency, prime brokerages have been “putting pressure on hedge funds to evolve their relationships,” according to the survey. “Regulations enacted post-financial crisis continue to filter through the banking industry and impact how prime brokers service the hedge fund industry. Prime brokers are requiring managers to alter their relationships, which impacts how funds conduct their core trading and financing processes. Almost 60 percent of managers say their prime brokers have requested fundamental alterations to their relationship to keep it economically viable.”
In addition, prime brokers are re-evaluating the types of managers they will work with, “and managers have responded by engaging with an increased number of prime brokers, as managers reported to use an average of 3.9 prime brokers,” according to EY.
“Managers and their counterparties continue the dialogue as to how to best partner together in light of funding, balance sheet and liquidity considerations,” says Graeme McKenzie, EY Asia-Pacific Leader, wealth and asset management, in a prepared statement. “The landscape has become significantly more challenging as managers increase the number of financing relationships while each individual relationship is becoming more complex to manage.”
The evolving relationship with prime brokers and the big push for operational efficiencies may help firms as they adjust to new investor preferences that are compelling hedge funds to make changes to keep clients happy, according to the survey.
For instance, the survey finds that nearly half, or 48 percent, of investors say they want their hedge fund investments to “shift from traditional hedge funds to other alternative products over the next three to five years,” according to EY.
A key driver for new investor demands is that fund growth is slowing “for a variety of reasons — the abundance of low fee passive investment options, lackluster hedge fund performance and cost concerns,” according to the survey. “In 2016, the proportion of North American investors that said they were reducing allocations to hedge funds exceeded the proportion that were increasing for the first time since the financial crisis of 2008.”
Investors have greater leverage because there are “more options than ever within the alternatives marketplace” and they are moving money to managers “that have a unique offering that is satisfying a specific need,” according to the survey. In response, hedge fund managers must actively listen to investors.
“Growth is the industry’s top priority, but managers are changing the strategies employed to achieve it,” says Michael Serota, EY global leader, hedge fund services, in a statement. “While we find the largest managers pursuing several growth strategies, the smaller managers are more narrowly focused, seeking to expand investor bases within their home markets. Amidst today’s challenging environment, it is imperative for managers of all sizes to identify the needs of their clients and align product offerings to their demands.”
A differentiator is innovation and “nearly 50 percent of managers utilize next generational data and/or artificial intelligence as part of their investment program,” according to the survey. “More than half (56 percent) of managers say asset growth is their first priority, but they are also facing an unprecedented change in investor appetite that can affect growth strategies.”
A sizable amount of investors surveyed, 42 percent, want a shift from “co-mingled hedge funds to customized vehicles and segregated accounts,” according to the survey.
“However, some managers are falling behind on investor demand for products. Although investors have a broad appetite for real assets (63 percent invested), private equity (59 percent invested), long only funds (56 percent invested) and best ideas funds (51 percent invested), only a small percentage of hedge funds currently or plan to offer these products,” EY officials say.
Large hedge fund managers have the upper hand and can “attract capital, as one in three of the largest managers offer private equity, real asset strategies and best idea vehicles, compared to single- digit percentages for smaller managers,” according to EY. “Mid-size and smaller managers do anticipate catching up as 33 percent of mid-sized managers and 48 percent of small hedge managers see their firms offering some non-traditional hedge fund products in three to five years.”
One area of consensus is agreement that next generational technology and data can enhance investment programs and attract investors.
“More than half (52 percent) of managers use non-traditional or next-generation data and big data analytics to support their investment process, or plan to do so in the next two to three years,” according to the survey. “The smallest managers are the most active, with 59 percent indicating that they use this technology.”
Assets are “flowing to the managers that offer a wide array of non-traditional hedge fund products,” says Natalie Deak Jaros, EY Americas co-leader, hedge fund services, in a statement. “Managers that do not respond to changing preferences must ensure they offer something unique to potential investors,” Jaros says.
In addition to new pressure on the kinds of investment vehicles they want, investors are ramping up the pressure on fees, which serves as even more evidence that managers need to innovate and optimize processes to control and cut costs.
“Hedge fund managers’ average operating expense ratio is down from last year, but investors feel there is still room for improvement,” according to EY officials. “Lack of performance, the plethora of lower cost alternatives and investors’ increased comfort in trading on their own behalf is causing them to challenge fee terms with their managers.”
Including management fee, the expense ratio is down from 1.95% in 2015 to 1.84% in 2016 as investors apply pressure, EY says. “The declines in management fees are driving this trend as average reported fees for 2016 were 1.35%, down from 1.45% in 2015. Despite this downward trend, only 20 percent of investors are currently satisfied with the expense ratios of their funds.”
EY is making the survey available at ey.com/hedgefundsurvey.
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