Regulation unlikely to protect investors, according to E&Y study

InvestorsLegalOperational RiskPeople MovesRegulation
05 Nov, 2012

Just 10% of investors believe regulations will protect their interests, while 85% said these new requirements are unlikely to prevent the next financial crisis, according to Ernst & Young’s latest global hedge fund market survey.

Managers are bracing themselves for an array of new rules including AIFMD, FATCA, Dodd-Frank’s Form PF requirements and mandatory swap clearing. “We should not be surprised by the findings about investor sentiment on regulation. Many investors view macro issues about financial stability as being primarily concerned with banking, the eurozone crisis and sovereign debt crisis, which are the biggest threats to the financial system. Therefore they do not feel hedge fund regulation is going to be that effective in mitigating these risks going forward,” said Ratan Engineer, global leader of Ernst & Young’s asset management practice in London.

“It would still be worthwhile for hedge fund managers to engage constructively with regulators to help them stay focused on the main goal – financial stability – rather than introducing more costly or unnecessary requirements that investors feel are of little value," he added.

These rules are also going to ramp up operational costs at a time when pressures on revenues and margins are rising rapidly. Thirty-four percent of managers said they had spent money upgrading their compliance functions while 17% acknowledged overheads for reporting technology had increased.  Some 45% of managers have also added headcount in the middle office, back-office, risk management and legal/compliance departments to deal with regulatory requirements, as well as investor transparency demands.

While investors anticipated such cost increases, many fear these expenses will be passed onto the funds. “There has always been a longstanding battle with investors and managers about the nature and extent of the costs which should be passed onto the funds. Given the current economic climate, there is a significant amount of pressure on costs and investors are understandably resistant to further cost increases,” commented Engineer.

Others predicted the increased costs will result in a barrier to entry and further consolidation among hedge funds. "The general increase in costs, including regulatory-related expenses, has created barriers to entry and has resulted in the consolidation of funds that do not have the capital to support the costly infrastructure required. This is a trend we will likely see continue in the near future," said Arthur Tully, co-leader of Ernst & Young’s global hedge fund practice.

Investors and hedge fund managers have also made little progress since 2010 in reconciling their opinions of how compensation should align with risk and performance, the survey added. In fact, opinions appear to be diverging. The survey said 87% of managers felt risk and performance were aligned with investor objectives compared with just 42% of investors. In 2010, 94% of managers and 50% of investors believed this respectively.

The survey highlighted two-thirds of managers said their compensation structure has not changed since 2009 with 14% stating less is paid in cash while 10% acknowledged they are subject to longer deferral periods. Investors, however, believe less than 40% of compensation should be paid in cash with a larger portion paid in equity and deferred cash subject to clawbacks.

Such shareholder activism is not just unique to hedge funds. A recent Schulte, Roth & Zabel survey revealed 79% of respondents expected the financial services industry to experience the most shareholder activism over the next 12 months.  “Shareholder activism on what managers should be paid is not a fundamental issue. Investor and hedge fund interests are better aligned than in other industries and the majority of managers pay some or all of their bonuses into their fund,” said Engineer.

The survey said managers believed that historic long term and short-term performance were the top two criteria for hedge fund selection. Investors viewed the hedge fund investment team (82%) as the most important criteria, followed by risk management (70%) and investment philosophy (66%). Managers (86%) overwhelmingly viewed performance concerns as the primary factor behind redemptions, as do investors (86%). However, many investors (84%) will redeem if there are changes in personnel at their hedge funds.

"Turnover is a communication issue for funds. Managers that communicate openly and honestly with investors about changes in the team and performance issues may give investors the confidence they need about their future returns to keep them from pulling out of the fund," said Tully.

Investor interest in emerging and start-up managers is also increasing, particularly from funds of funds. These funds of funds are often aggressive in demanding fee concessions, with 95% stating they negotiated reduced fees. This is often in exchange for larger mandates and longer lock-ups.  “Funds of funds have been under acute pressure to justify their worth and reduce overheads since 2008 so it is almost inevitable they will try to reduce the fees that managers charge,” commented Engineer.

The survey interviewed 100 hedge funds running $710 billion in AuM and 50 institutional investors worth $715 billion in AuM.

AIFMDcompensationDodd-FrankErnst & Youngeurozone crisisFATCAForm PFmandatory swaps clearingrisk managementSchulte Roth & Zabelshareholder activismsovereign debt crisis