External Costs

The relationship between hedge fund and service provider has been under increasing scrutiny in recent years as both parties look to squeeze the other for savings and revenue. Having previously analysed internal costs, this report’s third section explores the external factors impacting hedge fund business margins. From service provider relationships to technological disruption, we look at the key outside expenses as well as the techniques managers are using to run more efficiently.
September 2017

Report Overview

Service providers – value for money?

Like their clients, hedge fund service providers are feeling the squeeze. This is good news for hedge fund managers. Business is fluid, competition is rife and many providers are offering fee concessions and/or additional services.

i) Administrators – under pressure

Almost half of hedge fund operations professionals surveyed by HFM Insights had successfully renegotiated fees with their administrator over the last 18 months, well ahead of the rate for other service providers (Exhibit. 3.1). Indeed, our interviews with industry professionals suggest most managers are making a concerted effort to reduce administrator costs. And it seems that many administrators are unwilling – or unable – to give managers the savings they crave, with over 23% of survey respondents admitting to changing administrator in the same timeframe (Exhibit 3.2).

Exhibit 3.2 Analyst Note: No-one answered yes to ‘Legal advisor(s) onshore’ or ‘Legal advsior(s) – offshore’

ii) Legal advisors – room for negotiation

Although none of the managers interviewed had changed legal advisor, many had negotiated down their legal fees, with 35% successfully having done so with their onshore legal advisor and 31% with their offshore legal advisor. New funds may be surprised by how expensive legal fees can be, especially those operating regulation-heavy structures such as Ucits, where the total set-up cost can exceed $500k. The manager of one Ucits fund which cost $400k to set up stated that legal fees were the largest single item. A COO at a small London-based firm HFM Insights interviewed undertook a $10k self-assessment training course with a prominent industry law firm, learning how to review legal documents. As a result, his firm has saved considerable sums by reducing their reliance on outside counsel and reviews.

iii) Auditors – fund versus firm

Auditors appear to have had an easier time of it than many hedge fund service providers, with more than 90% of managers staying put in the past 18 months. Nonetheless, the ‘Big Four’ auditors are only too aware of manager interest in less expensive providers. Where once a firm may have used a ‘Big Four’ provider across the board, they are retaining a ‘Big Four’ provider for the fund audit to keep investors happy, but looking to smaller accountancy firms to provide services for the management company. One smaller auditor HFM Insights interviewed recently charged £7k ($9k) for a full audit for which a ‘Big Four’ auditor had charged £25k ($32k) the year before. The firm has a growing roster of hedge fund clients.

Almost one-third of respondents changed their compliance consultants in the past 18 months

Managers looking to save money on accounting costs might also consider changing the time of year at which they are audited to avoid, if possible, the expensive ‘busy period’ in the run-up to the end of the tax year. Service providers also benefit from the fact that the hedge fund industry does not rotate auditors in the same way other industries do.

iv) Prime brokers – mini-prime uprising

Prime brokers saw the lowest level of renegotiations among the HFM Insights survey respondents at 18%. However, 17% of managers took the more drastic step of changing provider, higher than the average for all categories of service provider. The changes to the prime brokerage landscape since 2008 have created a need for higher margins in an industry where many services have historically been regarded as value add. This has meant that, as well as prime brokers culling hedge funds, many managers have been swapping higher tier primes for mini or prime of prime solutions.

v) Compliance consultants – high drama

It’s been a dramatic few years for compliance consultants. Almost one-third of HFM Insights survey respondents changed their compliance consultants in the past 18 months and roughly the same proportion renegotiated fees. As stricter regulatory regimes such as Mifid II have approached, new companies have emerged and technologies developed in a bid to ease the burden on funds. Several interviewees said this was an area ripe for a holistic solution, which could cover all areas of the ‘reg-tech’ industry. A host of fintech companies are creating solutions capable of saving managers time and money. The bigger question now is not whether to use technology, but how to use technology. The difference between getting the answer right and wrong can be very expensive indeed.
Integrating technology – which method?

Using a strategic partner to access new technologies creates a bespoke service, but also a trusted adviser in an area where a manager’s expertise may be limited. The drawbacks in establishing such a relationship include: time consumption; opening up the firm to ‘outsiders’; as well as tying it to a single provider for the length of the relationship. As we see from Exhibit 3.3, just 16% of sub-$500m AuM managers adopted this approach and only 20% of managers with $5bn in AuM or more. These figures suggest many funds may be unwilling to commit to such a relationship, despite the significant potential benefits with regards to cost and production.

The large input costs involved in developing technology internally means few smaller firms will choose this option

Almost one-third of managers with between $500m and $5bn in AuM have purchased an existing platform, the highest among the three groups, while the option proved less popular among small and large managers, at 26% and 15% respectively. The large input costs involved in developing technology internally means few smaller firms will choose this option, just 16%. The proportion rises to 23% for managers with between $500m and $5bn in AuM, the same proportion as for outsourcing, indicating that it is this stage when a hedge fund firm begins to differentiate itself.

Outsourced access

Smaller managers clearly preferred accessing new technologies via outsourcing, with 42% having elected to do so. One margin-sensitive manager said his motivation for outsourcing was the ability to charge the service to the fund and benefit from a lean business, while another noted that not only did outsourcing help to reduce costs, but it also allowed access to a greater depth of expertise and skills. This manager also pointed out that by outsourcing his fund was covered when key members of staff were absent.

Just 4% of managers with $5bn or more in AuM favoured outsourcing as a solution and this group was the clearest cut in respect of developing technology in-house, with 50% opting to do so. Larger managers interviewed by HFM Insights also indicated that their preference was to keep functions in-house, as this gave them more control and security. One manager said that they do not outsource as the main point of contact can change and knowledge is then lost.

The investor opinion

While cost and productivity were the primary considerations for most fund managers when deciding to outsource, the views of investors are also key – but may be idiosyncratic. One recent study by trade body AIMA and mini prime broker Global Prime Partners (GPP) found that 39% of investors believe that excessive outsourcing would negatively sway an investment decision, compared to 35% taking the opposite view.

In the AIMA/GPP study, 44% of funds surveyed outsourced their CTO function, while 40% of investors expected firms to keep the position in-house. When it comes to the COO, however, a whopping 89% of investors expect managers to keep the role in-house. A large proportion of investors noted that outsourcing generally would not detract from due diligence scores, with 43% happy for middle office functions to be outsourced and 39% saying the same for the back office.

Exhibit 3.4 Analyst Note: Amalgamation of research, online sources, and interviews with specialists in each area. These figures are general expectations, calculated as an average of HFM Insights research, of change over the next 20 years.

The tech takeover

The date for when tech overtakes staff as a firm’s biggest cost is fast approaching – Exhibit 3.4 shows the hedge fund roles most at risk from the ‘tech takeover’. A recent report by consultancy firm Opimas estimated that 90,000 jobs could be lost within the asset management industry due to technology by 2025. Earlier this year Goldman Sachs released figures about their equity cash trading desk. Peaking at 600 in 2,000, the division now contains 2 traders and 200 computer engineers.

At the beginning of 2017, 45% of all trading was automated according to research firm Coalition, but cost saving will primarily be made in the day-to-day running of a firm through changes to the operational structure. ‘Augmented human intelligence’ will create the ability to communicate and solve problems better than any human, while Blockchain and other technologies of the future will create safer and self-recording transactions, nullifying many middle-office positions.

A survey of 458 asset managers by Create-Research and Dassault Systèmes asked respondents why fund managers are so invested in technology. Near to 75% of managers agreed that it was due to cost reduction and the need to reduce costs pressures. Insofar as costs were the primary concern, the heightened expectations of investors, who have become accustomed to 24/7 services, available at the touch of a button, were also a primary factor behind adoption of technology. The same survey found that over 30% of managers considered investor demands overbearing and that there was a need to use technology to be able to satisfy their expectations efficiently.

Fund charge or firm charge?

As part of our survey of hedge fund operations professionals, HFM Insights asked managers which costs they felt comfortable charging to the fund rather than the management firm (Exhibit 3.5). Some of the takeaways are as follows.

i) What’s acceptable

The vast majority of funds will pay for their service providers, such as administrator expenses. Respondents were partially divided over broker/dealer expenses, with almost 70% saying they would charge them to the fund and 22% passing them onto the manager. Travel, whilst controversial, was also deemed by some as an acceptable fund charge. One manager HFM Insights interviewed said most investors do not care about who pays for travel until returns drop.

ii) What isn’t

Perhaps unsurprisingly, third-party marketers were regarded by most as an item to be paid for by the manager, with more than 95% of respondents deeming this cost as unacceptable to charge to the fund, on a par with trader bonuses. Equally passing on the cost of attending conferences and industry events to investors was regarded as unpalatable, with 78% rejecting the practice. Bloomberg terminals, too, were deemed unacceptable as a fund charge by survey respondents, although this may reflect the slight European bias in the survey population. US managers, our interviews suggest, are more comfortable charging Bloomberg terminals to the fund.

Rules of thumb from interviewees were that fund costs should stay south of 15-20bps or have a 0.5% expenses cap and the rest should sit with the manager

iii) Grey areas

The real questions lie around research and trading technologies, even though these are broadly seen as necessities to fund performance. One-third of respondents believe that the manager should pay for research (excluding Bloomberg terminals), while 46% thought it should be paid for by the fund. Certain managers have stronger feelings on this than others, as one investor noted that either the manager accepts the costs or places them in a ‘practical research account.’ As Mifid II makes fees more transparent, this subject will likely become more pertinent. Especially when costs are as high as $600k – the fee charged by one European bank for their “top” research package.

Fund charges – rules of thumb

The sentiment of several HFM Insights interviewees suggested that fund costs should stay south of 15-20bps or have a 0.5% expenses cap and the rest should sit with the manager. But even those firms toeing the line on cost will be questioned by savvy investors from time to time. Ultimately, a manager’s power will depend on its performance, pedigree and investors. One US-based operations professional who regarded his firm as a “true alts shop,” said all of their costs were fund costs, the implication being that performance and pedigree ensured no push back.

Methods for improving margins

The report’s final exhibit looks at methods of improving margins employed by hedge funds, both in the preceding and coming 18 months (Exhibit 3.6). Renegotiation of service provider fees was a consistent theme in HFM Insights’ discussions with managers, a trend reflected in the data, with 37% of respondents having done so in the past 18 months and 26% planning on doing so in the coming year and a half.

A perhaps surprising strategy for cost management hedge fund managers have taken is to launch new, lucrative products or services. More than one-third of respondents said they planned to launch a new vehicle in the next year and a half, making this the most popular choice for improving margins into the future. In addition, this was the second most popular method (along with switching service provider) over the preceding 18 months.

This suggests hedge fund firms believe there is demand for new products, and the ability to leverage existing infrastructure makes it a tempting choice. By comparison, just 16% of respondents had streamlined their product range. The same proportion plan to do so in the coming months. Even with the additional costs of adding a new product, there are benefits, not only in additional capital, but also in bulk discounts and the spreading of staffing and infrastructure costs between multiple income sources.

As managers in the US continue the outsourcing trend, it is surprising that only a combined 21% have used this method to reduce costs in either the back or middle office. None of our survey respondents saw this as a viable solution going forward. However, as technology continues to transform the asset management industry generally, and managers increase their use of public services for functions such as data storage, this is an area that will be interesting to watch.