Shifting allocations drive hedge funds to new products

As institutional investors are no longer increasing their allocations to hedge funds, hedge fund managers bet on new products to drive growth. But many managers are underestimating the impact rising costs will have on margins, according to a global hedge fund and investor survey by Ernst & Young.

In North America and Europe, the number of institutional investors that aim to reduce their allocations to hedge funds outweighed those who plan to increase allocations by 25 percent. Worldwide the share of both groups was even.

The share of institutional investors surveyed for the report who were expecting to grow the portion of hedge fund investments in their portfolio dropped to 13 percent from 20 percent in 2012, and to 17 percent last year.

About 40 percent of investors named their objective of not wanting to allocate too much to a single asset class as the main limiting factor.

Michael Serota, co-leader, Global Hedge Fund Services at EY, said given this backdrop, managers are trying to offer investors more flexibility on fees and tailored offerings via separately managed accounts and long-only funds.

While separately managed accounts increase operational complexity for the manager, they can help overcome investors’ fee objections and allow managers to tailor offerings to meet investor needs, the EY report noted. Managers also develop registered liquid alternatives, which are in demand in Europe.

Most managers are doing so in the hope of attracting a new class of investor, private wealth platforms, which traditionally relied on mutual funds, to drive growth.

“The largest managers are even developing sub-advisory capabilities and insurance-related products,” Mr. Serota said.

Although new products may attract new investors and grow assets, a considerable number of managers have experience a negative impact on margins.

Overall, one in four managers who launched a product in the last three years said it had hurt margins. The biggest negative effect was from offering sub-advisory arrangements, UCITs and separately managed accounts.

This impact of new products is only logical, said Fiona Carpenter, EMEIA Leader, Global Hedge Fund Services at EY. “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,” she said.

“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 requirements add to the cost burden for funds.

“Regulatory reporting expenses, which were negligible even a couple of years ago, have grown significantly and are now impeding managers’ bottom line,” said Natalie Deak Americas co-leader, Hedge Fund Markets, EY. “For smaller managers it represents nearly a 7 percent drag and is creating a clear barrier to entry for new and emerging funds.”

In addition, the report, “Shifting strategies: winning investor assets in a competitive landscape,” found that cloud computing and cybersecurity have become major concerns across the hedge fund industry for regulators as well as investors.

Of all managers surveyed, 85 percent said that security concerns are the main impediment to using the cloud, and although 80 percent of managers expect to increase their expenditure on cybersecurity, few have made investments so far.

Accordingly, fewer than one in three investors are confident in their managers’ cybersecurity policies.

Ernst & Young will discuss the findings of the report and other industry issues at the Global Hedge Fund Symposium in the Cayman Islands on Thursday.

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