As the hedge fund industry has matured, firms’ cost structures have grown. The increase in expenses has accelerated recently as firms have scrambled to invest in new technology and additional staff to meet the challenges of rapidly changing market, industry and regulatory environments. Some hedge funds have not responded to this need in a strategic or structured way to create long-term solutions.
Hedge funds can control costs by analysing their vendor relationships, managing them better and maximising the leverage on their service providers, whether it’s their fund administrators, custodians or prime brokers. Funds must learn to harness the power of the technology that these service providers have, as well as the investments they have made in their own technology.
Managers can also optimise their cost structure by automating some of their current data gathering, normalisation and reporting capabilities to support the repeatable processes that are going to be the norm going forward. This requires tackling data and technology challenges in new ways.
What are the cost drivers?
Almost half of the respondents to Ernst & Young’s 2012 hedge fund manager and investor survey, Finding Common Ground, said that their costs had increased in the past year. In North America, 60% of the respondents reported higher costs. According to the survey, the funds that reported higher costs saw average increases of 15%.
Three factors are driving most of the acceleration in the rate of cost increases. The first factor is that as common strategies become crowded, funds have sought to generate alpha using increasingly complex investment strategies. These strategies often require new models, market data, trading technology and back-office support.
The second factor is the demand from investors for more granular and timely performance data. Investors want this in order to make their portfolio allocation choices, manage their risk and ensure their investment guidelines are being followed. However, most are not willing to pay more for this additional transparency.
According to the Ernst & Young survey, 90% of fund managers say their management fee is adequate to cover costs. However, that’s only because they are passing more and more expenses directly through to investors by charging them to the funds. Investors are losing patience with footing the bill. The survey showed that more investors in 2012 objected to the cost pass-through than in 2011. For example, one-third of the investors polled in 2011 objected to regulatory exam costs being passed on to the funds — that rose to three-quarters in 2012.
The third cost driver is regulatory compliance requirements. These are particularly important in the US, because most hedge funds were not regulated prior to the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank requires that hedge fund managers disclose much more information to investors and regulators than they did in the past. In manycases, fund managers must update their back and middle office systems to accommodate these new data requests.
Ad hoc responses
Many hedge funds have not responded to these changes by approaching their technology investments in a strategic way to build a long-term solution. In most cases, this is because the three drivers are recent developments and fund managers have only had time to react tactically.
For example, although the largest hedge funds are actively investing in technology and looking to increase outsourcing, most managers are adding headcount in the middle and back offices to accommodate growth. In fact, the Ernst & Young survey found that roughly 40% to 45% of hedge funds are adding headcount in support functions — middle office, back office, risk management, and legal and compliance — to support expected growth, client demands for transparency and the increased regulations. This suggests that a meaningful proportion of hedge funds continue to operate inefficiently, under-leveraging technology and outsourcing solutions.
Outsourcing can be a good source of technology savings. Managers are looking to outsource a number of tasks, starting in the back office and moving to the front office. For example, hedge funds can outsource functions such as investor reporting and services, striking the NAV, allocating expenses and closing the monthly books.
Fund managers are considering outsourcing more middle-office functions. Tasks such as daily reconciliation, treasury and collateral management, end-of-day P&L and risk-management reporting are prime candidates for outsourcing. Service providers have invested in technology in recent years to develop the systems to handle these functions in real time. This has engendered enough confidence among fund managers for them to cut back on costly fund administrator shadowing.
On top of looking at outsourcing in a strategic manner, in order to control costs, hedge funds will also need to invest in technology to meet the demands of new investment strategies, investors and regulators. Some guidelines can help fund managers do so efficiently.
First, managers should think about their criteria and processes for selecting technology. The challenge is to find technology that can be used holistically across the firm. This will minimise the use of multiple, incompatible platforms and the duplication of data purchases and processing. For example, some firms have two portfolio management systems — one for fixed income and one for equity — which only serves to increase costs and inefficiencies without adding value. In reality, a firm can buy a system that handles both.
Second, managers should rationalize their use of current technology. Not all systems need to be replaced. However, it is important that all systems are up-to-date and used to their maximum capacity.
Third, managers should create effective governance over the use of data. Many funds have multiple warehouses and vendors for the same data, which is used by different parts of the organization. Putting a specialist or team in charge of gathering data from vendors and distributing it to users will help eliminate redundancies and inefficiencies.
Finally, fund managers should investigate systems that automate rote activities that are now done manually. For example, software can help automate 50% to 70% of processes around regulatory compliance.
Fund managers may find it difficult to invest the time to create and implement long-term, strategic technology solutions. Certainly the pressures caused by the need to meet investor and regulator expectations, and the increasingly competitive nature of the hedge fund industry, make it difficult for most managers to step back and think strategically. But, ironically, for a fund to thrive, it is important to slow down andcraft well thought-out plans to deal with present and future challenges in a cost-efficient manner.
Samer Ojjeh is a principal in Ernst & Young LLP’s Financial Services Office. Natalie Deak Jaros is a partner in Ernst & Young LLP’s Financial Services Office.