We are pleased to share our 8th annual survey of the global hedge fund industry. For the last five years, conditions have been volatile, and many in the industry have focused on transparency, cost containment, restructuring operating models and adapting to a heavy regulatory burden. But the focus is shifting to growth. And those in the industry are now looking at how best to address the needs and evolving expectations of stakeholders.

First, we would like to extend sincere thanks to those managers and investors who gave their time and shared their insights and who shaped the direction and development of this survey. Without their input, we would not have such robust results. We believe that it is the combination of the perspectives of these two groups – both their agreements and differences – that drives and shapes our industry.

Our survey found that growth is again the focus of managers. But increased competition for assets means that managers are taking a wide range of paths to growth. The main source of investor capital has shifted – from high-net-worth individuals, to funds of funds, to institutional investors, and now to private wealth platforms.

Investors are increasingly focusing on a targeted strategy and investment philosophy and the ability to tailor fees and terms to fit their needs. And the larger managers are taking a lead in customizing solutions to meet investors’ evolving expectations.

Managers with over $10 billion of assets under management (AUM) are continually launching new products, such as separately managed accounts, liquid alternatives, and long-only funds. Investor appetite appears strong for these products. But their impact on managers’ margins is noticeable due to their generally lower fee structures. Mid-sized and smaller managers focus on increasing growth through their current offerings to existing clients and reaching new investors.

Funds of funds are evolving as they battle to keep their share of the market through the use of registered products. Over half of our fund of funds respondents offer liquid alternatives – products reliant upon sub-advisory relationships to be successful. A balance must be struck in these relationships; managers need to view the services as economically feasible given the infrastructure needs and fee structure. If such relationships do not prosper, the liquid alternatives opportunity for funds of funds may become extinct.

In order to manage risk and address regulator expectations, it is critical to have the right structure and controls in place for new business initiatives and product development. Managers must beware the herd mentality when considering a new product launch. They may want to look to their peers in the traditional global asset management industry for lessons about what happens when product offerings are expanded too rapidly. In the traditional industry, many managers have evaluated their hasty expansion of products and are now making cuts to their offerings.

At the heart of the industry is the responsibility of managers to act as stewards for their investors. Managers recognize that this obligation – to help investors meet their financial goals and to retain their investors’ trust – is the key function of their businesses. Greater alignment of interests between managers and investors is needed, but how this will be achieved is not without debate.

Fund expenses are clearly an area of focus both for managers and investors. Our survey indicates that expense ratios have declined modestly over the past three years. Notably, about three-quarters of investors take no issue with the expense ratios of their funds.

Managers continue to be challenged by the combination of margin pressures and increases in the cost of doing business, particularly as a result of increased regulatory reporting and compliance requirements. Investors are largely sympathetic and have generally been willing to pay for regulatory and compliance-related expenses. But some larger investors have negotiated fee caps. Managers – particularly small and mid-sized – anticipate pushing more expenses through to their funds.

However, our survey results also indicate that managers are listening to what their investors are saying. Managers are responding to investors’ demands by:

• Improving transparency around expenses;
• Communicating more proactively;
• Establishing a clearer and more sensible sharing of costs.

Overall, there appears to be a growing recognition that the relationship between managers and investors is not a battle.

With regard to manager investments and expenses, outsourcing and headcount are key trends. Managers are making investments throughout their business in order to support their growth aspirations. Efficiencies and economies of scale appear to be achieved in the back office as headcount in this area has continued to decline. Investors seem comfortable with the reduction in full shadowing performed on third-party administrators, and they support the move to a partial-shadowing model. Investors also seem to accept managers outsourcing additional functions, such as middle-office and marketing, with some level of oversight.

However, managers’ responses continue to indicate a concern about service providers’ capabilities in these areas. The majority of managers are not aware of third-party providers’ capabilities with respect to non-NAV-generating functions. There is a clear need for better education and for development of such solutions. This is an opportunity for both service providers and managers to better understand capabilities and expectations. All parties, including investors, can benefit by advancing this dialogue.

For many in the industry, technology, security and infrastructure – and specifically cybersecurity and the cloud – are at the top of the agenda. Breaches and security issues are in the news daily. And global regulators are convening to determine how best to address concerns, raise awareness, and determine sensible governance and oversight.

About half of the managers we surveyed use the cloud. But many of the larger managers do not, citing security concerns as the primary barrier. However, many may be using the cloud without realizing it, because it is likely that some of their vendors are. Managers should be aware of the risks to their data via attacks on their service providers.

When storing data – whether in the cloud or on physical back-ups – managers need to have in place standardized, well-defined processes, controls and protocols. With appropriate security and controls in place, the cloud can provide an efficient and less expensive way for managers to store data. Regardless of whether managers use the cloud or not, cybersecurity will be a concern for managers and a focus for regulators.

Only a minority of the investors who responded to our survey are confident in their managers’ cybersecurity policies. However, a vast majority of managers intend to make additional investment in this area.

Closing thoughts
Growth is the shared destination, but there are many ways to get there: developing sensible new products; making strategic investments in technology, people and infrastructure; enhancing the brand; and simplifying the business by focusing on what you do best, and how to do it better. There are many exciting growth opportunities for the industry. But they don’t come without challenges.

At a time of heightened competition, managers must cater much more carefully to investor needs and preferences in order to win assets. Managers must be willing to customize their offerings to specific client types. This could involve adjusting fee levels and expense ratios, providing separately managed accounts or supplying registered liquid alternative products. Simply offering these capabilities will not alone be enough, however. In today’s environment, managers must work hard to differentiate themselves from the competition. They must provide a compelling explanation of their investment philosophy and processes. And to turn these developments into growth, managers need to investin:

• Marketing and distribution talent;
• Front-office capabilities to support strategies;
• Infrastructure to support products.

At EY we are enthusiastic about the future of the industry. We look forward to continuing our work with you in this robust and meaningful global industry.

Michael Serota Co-Leader, Global Hedge Fund Services
Arthur Tully Co-Leader, Global Hedge Fund Services
 
MANAGER INVESTMENTS AND EXPENSES
Managers continue to be relentless in their goal to achieve efficiency. Allocating time and resources to improving the front, middle and back offices has been the trigger to reducing operation costs and minimizing the drag on margins. In this section we discuss:

• Where investments are being made
• Regulatory reporting and technology expenses
• Achieving efficiencies
• Outsourcing and shadowing

Investments continue in legal or compliance issues and risk, as managers begin investing across other functions to support growth
Investments in legal and compliance functions do not appear to be abating as managers continue to find ways to streamline reporting functions. Managers have few alternatives to making these investments themselves, because there are limited technology or software options. Service providers currently offer regulatory reporting services – an area ripe for outsourcing. However, many managers have not relied on this option due to a lack of trust.

The largest managers are most likely to invest in the front office and in data management. Front-office investments are critical because these managers develop new strategies and products. Investment in data management supports many stakeholders at the firm. These investments are critical to the task of achieving efficiencies across the middle and back office. They support internal controls, risk reporting, portfolio management and effective outsourcing to service providers.

The smallest managers have fewer resources to invest. This is despite their ambitious growth plans and their need to identify opportunities to outsource – particularly in the middle office – to free up investment dollars.

"Throughout our history, we’ve always evaluated the buy versus build decision, as strongly in favour of build, not because we felt we had a secret expertise, but because the vendors were still developing the products. But, in the last five years, I think the service providers and software vendors have become more targeted, more focused and have really upped their game in terms of building products that are very customized to this industry. With this development, there’s now more availability of off-the-shelf products/solutions so that when you’re looking at the buy or build decision now, you’ll frequently decide that it’s best to buy from an efficiency and cost management perspective. This allows us to reign in our internal spend because we don’t need as many people to deal with specialized issues."
– (Manager, North America, $2b-$10b)

Expenses related to regulatory reporting are having a meaningful drag on margin and creating a barrier to entry
Expenses related to regulatory reporting are bearing on margins and creating a barrier to entry. Regulatory reporting expenses were negligible a few years ago. However, this cost has risen recently, and it is now significantly affecting managers’ bottom line. This added cost cantranslate into an average material drag on margins of 6%, assuming a historical margin of 30%.

Given their lower overall cost base and limited ability to pass through expenses to the funds, the smallest managers are most affected by the added expense. For them, it represents an almost 7% drag on margins. Bearing the cost of regulatory reporting creates a clear barrier to entry for new and emerging funds.

In contrast, large managers are insulated by larger cost bases and have been investing in automated reporting solutions to reduce the burden of regulatory compliance. Managers in Asia tend to have a lower cost associated with regulatory reporting as these functions have largely been outsourced.

Technology expenses continue to increase
The largest managers are spending the most. They are making strategic capital investments in technology to continue to scale their operations. Investments have moved to two key areas: data management and integrated front-office systems that create efficiencies between the front and middle office.

Whereas managers used to integrate disparate best-of-breed technologies, they are now implementing more comprehensive systems that link portfolio management and order management with risk, compliance and accounting systems. A key to making these systems work is data governance and enterprise-wide data management.

History is repeating itself. In the past, managers made material investments in back-office automation, only to outsource those functions to administrators a few years later. As managers seek additional efficiencies, they feel compelled to invest in technology, even as administrators’ middle-office capabilities continue to develop. Service providers that succeed in demonstrating proficiency in middle-office processing will have a clear competitive advantage.

Technology investments, combined with outsourcing, are resulting in headcount efficiencies in the back office
Over the last few years, investments in automation, effective outsourcing and a concurrent reduction in shadowing or replication have helped managers to achieve efficiencies in the back office. Mid-sized managers have realized the most efficiencies in the past several years. They are now achieving ratios of support personnel to front-office headcount in line with those of the largest managers.

Although leading managers appear to be approaching the achievable limits of headcount reductions, the industry can secure additional efficiencies from middle-office outsourcing and continued investment in technology. In addition, there remain managers of all sizes that have clear opportunities to realize efficiency from technology, outsourcing, and a reduction in shadowing and replication for outsourced functions. Reduction in the average ratio of back-office FTEs to front-office FTEs will continue to diminish for larger managers unless these managers take a holistic assessment of their operating models.

There is meaningful differentiation by strategy. Managers that offer distressed and credit strategies are considerably less efficient than managers that offer only long/short equity. Back-office processes – including valuation – for these strategies are complex, and outsourcing solutions remain less reliable.

Back-office functions are largely outsourced, but middle-office remains in-house
To no one’s surprise, back-office functions related to net asset value (NAV) and financial statement generation continue to be predominantly outsourced. The only funds holding out on these functions are those with complex structures and/or trading strategies, and those funds that have developed what they believe to be superior technology and internal processes compared to those offered by administrators.

Outsourcing for middle-office functions is much less common, and is an area ripe for consideration for managers looking to reduce the workload and cost of their internal infrastructure performing these tasks. Fewer than half of managers currently outsource middle-office functions despite advances made by third-party providers in these areas, in addition to growing investor comfort with managers’ relinquishing control of these responsibilities.

Historically, managers in Europe have been keener to outsource than peers in other regions. Since the financial crisis and the Madoff investment scandal, managers in North America have closed the gap noticeably. This is a result of investor demand for independent oversight and a need to improve cost structures.

Investors are increasingly comfortable with outsourced operations
Fund managers continue to resist outsourcing functions outside of the core back office. This is despite the fact that investor responses once again show an increased level of comfort with managers leveraging the solutions offered by various third-party vendors for almost all middle and back-office tasks. Investors are overwhelmingly tolerant of managers outsourcing everything, from daily reconciliations and pricing to collateral management and shareholder reporting. In fact, risk and portfolio management are the only two functions identified by investors as not permissible for outsourcing.

Given this current state, managers should be exploring the solutions provided by third-party vendors and understanding where they can leverage opportunities to scale back the functions currently performed in-house. Whereas in the past an expectation may have resided that investors wanted greater manager involvement in these areas, the climate has certainly changed, presenting a window of opportunity for managers to re-evaluate and enhance existing business models.

Middle-office outsourcing represents the new frontier for additional cost savings
Managers do not yet see middle-office outsourcing as a viable alternative. As a result, they continue to make significant investments in middle-office infrastructure. Many managers see these functions as too closely tied to the front office. They believe that the required coordination between the middle office, investment professionals and risk management would be impeded if middle-office functions were outsourced. Furthermore, they do not perceive the capabilities of third-party service providers for these functions to be as mature as those for back-office processing.

As an alternative to investment, managers should consider working closely with their service providers to advance their capabilities. Service providers should see this as a call to action and continue to invest.

Reduced replication of outsourced functions can improve efficiencies
Fully replicating outsourced functions negates the cost savings that a manager could realize from outsourcing. Yet, judging by the pervasiveness of full shadowing, it would appear that many managers are unwilling to eliminate this duplication of effort. This reticence is explained by the need to ensure that they have appropriate checks and balances on their administrators and to mitigate risks of business continuity and disaster.

It is to be expected that when managers move to outsource certain processes for the first time, they will fully shadow until comfortable that their service provider is sufficiently processing these new responsibilities. It is surprising that functions with a track record of successful outsourcing, such as NAV calculation, continue to receive full shadow treatment from a majority of managers.

Investors prefer moderate oversight
Administrators should see this as an opportunity. Managers will always do some replication, but administrators can raise comfort levels with their processes. They can prove to managers that they have adequate controls in place to prevent costly errors, that they are sufficiently capitalized and committed to the business, and that they have disaster recovery plans in place. Investors by no means are saying they expect no involvement from managers; however, an overwhelming response across all functions indicates they are comfortable moving away from the costly and time-consuming, intensive full shadow model that many managers use.

Investors are clearly more tolerant of oversight than are managers. They recognize that the redundancy increases the cost structure of their managers and impedes further reductions in management fees.

Investors are increasingly comfortable with a second “shadow” administrator, but will not want to bear the cost
Although investors appear increasingly tolerant of using a second administrator to shadow, they will rarely be prepared to bear the cost if passed onto the funds. Furthermore, it is unlikely that most managers would be willing to give up control and oversight of key processes.

This puts even more impetus on managers to identify the right balance between oversight and full replication. While there have been a few high-profile examples of managers using a second administrator, the movement has not yet gained widespread appeal.

CLOUD COMPUTING AND CYBERSECURITY
Across the hedge fund industry, cloud computing and cybersecurity have become acute concerns of investors and regulators. As a result, how to protect a firm from cyber-attacks is at the forefront of discussions across the hedge fund industry.

In this section we explore:

• Use of cloud computing
• Cybersecurity investments
• Steps to improve cybersecurity
• Investor confidence

Most managers do not use the cloud, citing security concerns
Managers point to security concerns as a key impediment to using the cloud. Although some security concerns are legitimate, they are not as acute as many managers believe. The lack of accepted security standards fuels fears as well as recent well-publicized breaches.

However, these types of targeted attacks could happen with most security systems that managers have in place.

Because they do not have in-house IT expertise and cannot invest in the hardware they need, smaller managers are more likely than the largest managers to use the cloud. But even the largest managers are likely to use third-party service providers that leverage the cloud. Managers who are evaluating the cloud, or have vendors that use it, can allay security concerns by conducting proper due diligence on vendors and hosts.

Should managers overcome their security concerns, they still need to evaluate the costs and benefits. Although using the cloud may reduce costs, this will have to be traded off with the lengthy and detailed due diligence that managers would need to perform.

Managers expect to increase spending on cybersecurity, but few have made investments
Although most managers are planning to spend more on cybersecurity, investments to date have been modest and superficial. Leaders are taking proper steps to secure not only their organization but their entire “ecosystem.” This includes vendors, business partners, service providers and even underlying portfolio companies.

Cybersecurity has been a topic of priority concern for regulators. Given this, and managers’ aspirations to target retail investors, investments in this area will become more critical.

Managers are planning to take a number of steps to improve cybersecurity but will need to do more
To date, managers have been focused on detecting intrusion, preventing external penetration attacks and monitoring email. They recognize the need for vendor oversight but many struggle with what it truly means. Managers that have not already done so should consider four key steps:

1. C-level sponsorship to review and approve policies and facilitate cybersecurity programmes.
2. Employee training about threats and the appropriate response.
3. Third-party oversight that extends beyond due diligence when retaining a service provider to ongoing oversight.
4. Developing a formulated and codified response to attacks, including appropriate disclosures that comply with regulations.

Although it is available, insurance for incident coverage may not be an attractive option. It is expensive, has many caveats and claims will force disclosure of a breach.

"Cybersecurity is on the radar of our top leadership. Our risk management committee has been evaluating our cybersecurity readiness while utilizing external vendors to perform various attacks on our systems. Any breaches of our internal or client data would be a damaging blow to our credibility and would certainly impair our ability to retain capital, let alone go to market to raise new funds."
– Manager, Asia, under $2 billion

Fewer than one in three investors are confident in their managers’ cybersecurity policies
It is not surprising that, among investors, the majority is not very confident in their managers’ cybersecurity policies or cannot offer a view. Most managers do not yet have fully formulated policies, and there is no standard methodology for performing due diligence on cybersecurity.

It is incumbent upon investors to learn more about cybersecurity and ask their managers to demonstrate how they are addressing it.

"Cybersecurity is absolutely the number one risk facing our business and the entire industry. As a result, we are incurring significant expenditures in our people, processes and technology in order to gain and retain investor confidence."
– Manager, Europe, over $10 billion