Three trends for global hedge funds in 2014


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By Robert Mirsky, KPMG,

The global hedge fund industry has a lot to be bullish about for in 2014. A recent survey by Barclays suggests that up to USD365billion of assets could be ‘in-play’ this year; the largest amount since 2007, with up to USD80billion in net inflows and USD285billion in reallocations.

Also, figures in the 2014 Preqin Global Hedge Fund Report show that hedge funds made gains of 11.08 per cent for the 12-month period ending 31 December 2013. That’s a slight gain on the 10.13 per cent figure for 2012 and a seismic shift from the benchmark loss of -1.93 per cent in 2011. A reassuring 84 per cent of investors said that last year’s returns had either met or exceeded their expectations.

These are encouraging signs. Speaking with Hedgeweek, Robert Mirsky, Global Head of Hedge Funds, gives his insights into what important trends will likely emerge this year as hedge funds start to rediscover their ‘mojo’.

There are three trends in particular that Mirsky identifies:

  • The ongoing drive for cost-effectiveness in managing hedge funds;
  • AIFMD as a catalyst for European hedge fund growth; and
  • The increased prominence of liquid alternatives.

1. Operational cost-efficiency

Beginning with the first point, Mirsky says that at KPMG they continue to see margins being squeezed. Fee compression is coming at a time when the cost of doing business is becoming more expensive.

“Looking back at our recent global survey, entitled The Cost of Compliance, the cost of regulatory compliance is 30 to 40 basis points depending on where you are situated. If 25 per cent of the management fee is being taken up with regulatory compliance it’s clear to see just how much operating margins are being squeezed,” says Mirsky.

Adversity breeds innovation. Faced with lower operating revenues, managers are focusing more closely on how they can run their businesses more cost-effectively. The increased use of new technology, particularly cloud-based technology, and willingness to outsource non-core functions is a trend that Mirsky expects to see continuing in 2014.

“We are seeing all kinds of new businesses setting up to take advantage of this and support a variety of outsourced functions that were traditionally kept in-house. Most administrators now are providing middle-office services, and we’re seeing managers think about how to effectively use outsourced providers across their business.

“Just a few years back we were seeing the desire among managers to spread their counterparty risk by using multiple prime brokers. What’s interesting is that now we are seeing managers choosing to use one key service provider to handle a variety of services from prime brokerage to custodial services to fund administration – something that many of the universal banks are well positioned to provide,” comments Mirsky.

This isn’t necessarily increasing counterparty risk because a lot of these are separate legal entities within the holding company with Chinese walls separating their activities.

For certain universal banks, this is now becoming a core part of their business strategy. After all, it’s not just managers, but also the bank institutions that support them, that are also facing increased revenue pressures because of capital restrictions under regulation such as Basel III.

The more these institutions can support managers by providing a full suite of services, the better for both parties concerned. This is all about giving managers access to the whole banking platform. A good example here is the AIFMD. Under this regulation, EU-based hedge fund managers will be required to appoint an independent depositary; yet another cost. One of the models emerging to support managers is an integrated AIFMD model where the three core services of asset safekeeping, cash management and general oversight of the fund are all performed under one roof.

This has the potential to keep cost to a minimum for the manager because all of the counterparty risk is centralized.

“One of the findings of the survey we conducted was that the average cost for a small hedge fund manager to cope with regulatory compliance is USD600K per annum. We subsequently received numerous calls from managers saying, ‘We don’t spend that much on regulatory compliance. We outsource things such as risk analytics to cope more efficiently with Form PF”.

“There are innovative ways of dealing with rising costs. If you aren’t looking to outsource as a smaller manager, you won’t survive,” says Mirsky.

“The average size of a hedge fund to break even today is probably around USD150million; that’s tough. There are still a huge number of hedge funds that are running less than USD100million in AuM so how do they survive? They survive because they are actively dealing with these costs.”

2. Regulation trends for 2014

“I think we’ll see managers continuing to focus their efforts on AIFMD and FATCA. The cost of regulation under FATCA, AIFMD, SEC/CFTC etc has been very high not just in dollar terms but the amount of management time taken up. However, it almost feels like we are starting to see a light at the end of the tunnel, at least for European-based managers in respect to the AIFMD,” says Mirsky.

The AIFMD will continue to dominate managers’ time into the summer but Mirsky thinks that by September “managers will start focusing once again on growing the business”. Indeed, one consequence of regulation is that there could be more emphasis placed by managers on offering regulated products as an alternative to traditional offshore products: either as listed funds, alternative UCITS or 40 Act funds “
I also believe that interest in raising European assets is starting to come back again. I do think that EU-based managers will need to think about how best to approach those markets because Europe will become an important source of capital again in the next 12 months.

“I think managers would be remiss to overlook the investor opportunities in Europe, maybe not right now but certainly in the next six to 12 months,” states Mirsky.

3. Demand for liquid alternatives

This is essentially part of the regulation narrative. Alternative mutual funds (aka liquid alternatives) have been gaining prominence in the US as a result of hedge fund managers having to become registered with the SEC as investment advisers. Both mutual fund houses as well as private equity and hedge fund managers have been increasingly launching single and multi-manager 40 Act funds to tap into a huge reserve of regulated assets.

“We expect to see more interest in 40 Act funds towards the end of this year and into 2015. However, managers need to be aware of the fact that these fund vehicles are not cheap to set up; it’s an expensive proposition. That said, it opens up the manager to a massive investor base. The 401 (K) plan in the US is the Holy Grail. Getting an alternative mutual fund into a retirement product suite is something every manager would want,” says Mirsky.

Whilst managers cannot charge performance fees for running one of these funds, this is offset by the hundreds of billions of investable dollars that are out there for managers to tap into. Mirsky is keen to add the following caveat:

“They offer great opportunities but there are also risks associated with costs, infrastructure requirements etc. Managers should also be careful that they aren’t cannibalizing their main product line – their offshore flagship hedge fund – by offering something that is ostensibly the same. It is and should be considered a different kind of product, one that is better suited to the regulated marketplace.”

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