Cost management; the perennial business issue. It might not be the most striking of topics, but it is without doubt one worth revisiting. For this report, we set out to present the latest data and opinion on hedge fund firm costs and cost-saving techniques, and to give the topic some much-needed context. This meant not only surveying operations professionals at hedge fund managers and interviewing service providers, but analysing the trends in launches and liquidations data. The group of firms to spin out from investment bank prop desks following the emergence of the Volcker Rule, for example, have produced some high-profile failures. Would this group – and others – yield some lessons for future cost managers?
The report’s first section, therefore, offers data on launches and liquidations and seeks to identify some commonalities between those firms that have survived and those that haven’t. We do this by analysing the first 100 start-up firms in HFM Week’s ’20 For’ series on ‘hot prospect’ managers, seeking trends by a founder’s pedigree and the strategy they are attempting to get off the ground. Founders who have worked at brand-name hedge funds were expected to do better than founders from elsewhere – and do – but have done so by perhaps an even greater margin than expected. Industry data on break even AuM by a firm’s investment strategy gives the findings even greater context.
From there the report digs into the costs themselves. After offering a breakdown of key expenses at the end of section one, section two looks at internal costs: those costs that a manager has the greatest control over. We choose to explore five key areas. Four internals costs: location, staff, marketing and expenses. And the main internal revenue generator: product fees. All five prompt pertinent discussion points, including the extent to which managers are moving out of expensive hedge fund hubs (they are, but not far), the types of firm most likely to pay for third-party marketing (mid-sized), and the balance firms are trying to strike when hiring and firing (US staff, it seems, are more expensive yet still better value).
The final section then covers external costs; chiefly trends in service provider fees and the impact of technology. The main upside of being in an unforgiving business environment, is that a firm’s vendors are feeling similarly squeezed. Some more than others. Hedge fund administrators have been particularly vulnerable to push back from their clients, although most managers have made some headway in reducing their counterparty outlay generally. However, once the race to the bottom on vendor fees is over – and the finishing line isn’t far – the real battle begins, one in which technology is the disruptor and headcount the casualty. Only those firms generating operational alpha stand a chance of survival.
Brand-name hedge funds produce successful new founders, mid-tier firms don’t
Working at a hedge fund may be the best education for traders looking to launch their own hedge fund business, but the size of the hedge fund firm they work at will have a huge bearing on a new founder’s chance of success. HFM Insights analysis of 100 ‘hot prospect’ new hedge fund firms found that half of those from founders who’d worked at a hedge fund manager with $5bn or more in AuM have gone on to launch a firm now in the ‘billion-dollar club’. Of the founders who’d worked at a manager with less than $5bn in AuM, no-one had launched a firm currently managing more than $1bn in AuM and more than half had seen their creation fold.
New products are the preferred route to boost profit, but squeezing service providers is the fall back
The most popular method for improving profit margins over the next 18 months among Insights survey respondents is to ‘launch a lucrative new product or service’, with almost 40% having such a plan followed by 26% who will concentrate on renegotiating fees with their service providers. The percentages for these categories were the other way around for the ‘last 18 months’, suggesting managers start out by intending to generate new revenue streams but ultimately end up trimming existing expenditure. Indeed, about 20% of managers reduced headcount in the past 18 months, while about 10% plan to in the next 18.
Firms are considering less expensive HQ locations, but they’re not moving far
The recent trend has been for managers to swap flashier districts and showy office blocks for less expensive parts of the same cities. Some firms are leaving traditional hedge fund hubs, Midtown Manhattan and London’s Mayfair, for the likes of Murray Hill and Marylebone. At the same time business rates in London have increased dramatically – one manager HFM Insights interviewed experienced a more than 60% rise after the recent UK government revaluation. Ultimately a balance needs to be struck. Cost saving is important, but while investors may baulk at excess, they still want to see signs of a successful business.
Founders with brand-name pedigree running non-equity products have the best chance of breaking even
Investment strategies may pick the trader rather than the other way around, but founders launching, for example, a new global macro hedge fund manager face different challenges to those launching an equity manager. On one hand, global macro, event driven and multi strategy funds have higher ‘break even’ AuM points than the average equity or fixed income hedge fund strategy. On the other, the appetite among investors for non-equity hedge funds from high-calibre founders is particularly high. Our analysis of the 100 ‘hot prospect’ start-ups suggests non-equity launches from founders that previously worked for $5bn+ hedge fund firms had the best chance of success.
Medium-sized managers are making the most use of third-party marketing
Hedge fund managers with between $100m and $1bn in AuM are most likely to use third-party marketers, with 36% of SEC-registered firms analysed by the Insights team doing so compared to 28% of larger managers ($1bn AuM or more) and 23% of smaller managers ($100m AuM or less). Why? Most smaller managers do not have the resources to hire such a service and will likely rely on their personal networks to get AuM off the ground. Many larger managers, meanwhile, will have the luxury of being closed to new investment already, or are benefiting from reverse enquiries and the efforts of their prime brokers’ cap intro teams.
Investor pressure on fees is mostly a problem for someone else, managers believe
One of the most striking findings from our survey of hedge fund operations professionals was that although managers regarded their own firm as having further to go on reducing fees, they viewed their own efforts far more favourably than the industry as a whole. Respondents were asked, ‘in terms of investor fee pressure, is the worst behind us?’. While most said ‘no’, the majority of those that said yes believed they were ahead of the curve. Just 11% of managers surveyed said the worst of the investor fee pressure is behind the industry, but almost 30% said so for their own firm’s situation.
Middle and back office workers are particularly vulnerable to the cost benefits of new technologies
Advances in technology in the coming years will have a devastating effect on the jobs market generally, and hedge fund back and middle office roles are among the most vulnerable. As the pressure on fund managers to find operational alpha intensifies, more firms will look to new technologies such as blockchain and machine learning as a way, not only to improve returns, but to run a more efficient business. As many as 80% of researchers and 60% of middle office workers could be replaced by such technologies, Insights research suggests. Hard-headed decision-makers will be unlikely to complain, as losses in human capital are replaced by more, and quicker, information.
Most administrators have either conceded to lower fees and/or lost hedge fund clients
If squeezing service providers on fees is a popular method for managers looking to save a few basis points, administrators are feeling the brunt of the efforts. Almost 50% of survey respondents successfully negotiated down their administration fees in the past 18 months, the highest percentage for any service provider, while almost a quarter had switched administration providers, the second most after compliance consultants. Hedge fund administrators are already under pressure to offer more services for the fees they are charging, and our research suggests many managers would rather have a lower bottom line.
Fixed income/credit hedge fund managers should be first to turn a profit
Fixed income firms have one of the best survival rates – and one of the better success rates for hitting $1bn in AuM – among the ‘hot prospect’ start-ups HFM Insights analysed, in part because they are quick to reach a profitable size. Fixed income/credit hedge funds have the lowest break even AuM among the major strategies at under $80m, and also produce the biggest profit for their managers, with a sizable difference between the group’s average management fee and average operating cost. Fixed income funds are profitable sooner and earn more when charging industry standard fees – and several high-profile credit launches have benefited in recent years.
The findings in this report were based on three primary sources: research interviews conducted in person and over the telephone, a proprietary online survey, and analysis of in-house and third-party data. Research was gathered between April and June 2017. In total, more than 50 firms contributed to our research. These were mainly hedge funds represented by operations staff, as well as service providers and investors.
Several of the exhibits in the report’s first section are based on the analysis of the 100 firms from HFMWeek’s first five ’20 For’ editorial features, an annual series showcasing the 20 most exciting new hedge fund firms globally. The managers chosen each year were those deemed most likely to achieve significant future success based on conversations with senior industry professionals and HFMWeek’s editorial judgement.
The 100 firms to feature in this report’s analysis were from: ‘20 for 2012’ (published September 2011), ‘20 for 2013’ (published August 2012), ‘20 for 2014’ (published September 2013), ‘20 for 2015’ (published September 2014), and ‘20 for 2016’ (published October 2015).