'40 Act hedge fund compliance costs could mean slow near-term growth, says KPMG
The ’40 Act hedge fund space will grow slowly in the near term due to the operational and compliance costs associated with chasing retail investors, although this could change over the next decade, a senior executive at KPMG has said.
“We are not seeing massive growth in the ‘40 Act hedge fund space at the moment but there is increasing interest. The cost of setting up a ’40 Act hedge fund is not insignificant, but I believe in the longer term these vehicles will blossom,” said Robert Mirsky, global head of hedge funds at KPMG in London.
Service providers have been bullish on 40 ‘Act hedge funds. Citi Prime Finance predicted $939 billion of the $12.8 trillion in retail assets would flow into what it dubbed liquid alternatives by 2017, while McKinsey & Co pointed out retail alternatives as an asset class had grown by 21% annually since 2005 and currently managed around $700 billion. A report by SEI highlighted assets in US alternative mutual funds and exchange traded funds (ETFs) had more than doubled since 2008, standing roughly at $554 billion.
While the distribution benefits are hard to falter, regulated alternatives such as 40 Act Hedge Funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 bps and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding.
“The biggest dis-incentives for establishing a retail hedge fund are the cost factors, investment restrictions and lower management fees. It generally does not make economic sense for a sub $1 billion manager to build a ’40 Act hedge fund product. Furthermore, establishing a ’40 Act hedge fund could prove a distraction for the manager to running their flagship fund. This means ’40 Act hedge funds will be the preserve of the larger managers for the time being. I believe in less than 10 years, ’40 Act hedge funds will be mainstream but managers have to first educate retail investors about the benefits of regulated alternatives,” commented Mirsky.
One of the key investor targets among managers running regulated alternatives is the DC plan market, said SEI. Sixty per-cent of the DC plan market’s $5.1 trillion in assets are in mutual funds, and this investor class has historically been averse to alternatives. Nonetheless, some plan sponsors are becoming bolder and are increasingly investing in real-estate, inflation protected Treasuries and commodities in search of greater yield. Access to retail clients via brokerage platforms would also help managers bolster their asset base.
Several brand name private equity and hedge funds, most notably AQR, Blackstone and Apollo Global Management have recognised these potential opportunities, and have developed alternatives vehicles aimed at retail, with minimum investments as low as $2,500 in some cases. AQR has been one of the biggest enthusiasts for retail alternatives, having launched 20 mutual funds which are now running $9.2 billion.