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