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Global Hedge Fund Survey 2012: Growing doubts among investors on the benefits of hedge fund regulation

Zürich (ots)

New regulations and compliance requirements are taking a financial toll on hedge funds, with the cost of doing business continually on the rise. As the Ernst & Young Global Hedge Fund Survey 2012 shows, investors are doubtful that the more stringent regulations will be of any benefit. When it comes to the topic of aligning compensation with risk and performance, there is still a major disconnect between the opinions of hedge fund managers and investors.

ZURICH/GENEVA, 16 NOVEMBER 2012 - According to Ernst & Young"s annual global survey of the hedge fund market, only 10 percent of investors feel that the increasing regulatory requirements for hedge funds effectively protect their interests, and 85 percent of investors do not believe these requirements will help prevent the next financial crisis. These are two of the insights of the survey conducted by market research and consultancy firm Greenwich Associates on behalf of Ernst & Young. The survey comprised 100 hedge fund managers with assets under management exceeding USD 710 billion, as well as 50 institutional investors with hedge fund allocations totaling over USD 190 billion.

Swiss investors do not see any benefit in the new hedge fund regulations, and the vast majority of them are critical of their proliferation and purpose. The survey shows that it may still be worthwhile for hedge fund managers to constructively engage with regulators to help them stayfocused on the main goal - financial stability - rather than introducing costly or unnecessary requirements that investors feel are of little value.

Regulatory compliance Hedge fund managers will need to commit time and resources to understanding and complying with various regulatory requirements. Managers are already seeing their costs increase due to changing compliance functions (34 percent) and technology reporting (17 percent). Although investors expect these additional compliance costs, they fear these expenses will be passed on to the funds.

Christian Soguel, Leader of Asset Management, Ernst & Young Switzerland, says: «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 to continue in the near future».

Compensation Investors and hedge fund managers have made little progress since 2010 in reconciling their opinions of how compensation should be aligned with risk and performance. In many ways, they are drifting further apart. 87 percent of managers feel risk and performance are effectively aligned with investor objectives, compared with 94 percent in 2010. Only 42 percent of investors agree, down from 50 percent in 2010. In addition, more than two-thirds of managers say that their compensation structure has not changed in the past three years; just 14 percent say that less is paid in cash, and just 10 percent say that compensation is subject to longer deferral periods. Investors, by contrast, say less than 40 percent of compensation should be paid in cash; they would like to see a larger portion paid in equity and deferred cash, subject to clawbacks.

The gap between managers and investors on compensation structures is not new. However, the fact that it shows no sign of narrowing, but is even increasing, can be seen as a troubling development in investors" confidence in managers. Nevertheless, this dissonance has not caused material redemptions, nor do investors cite compensation as a key consideration for choosing a fund. Investors prefer greater investment of own funds by the asset manager in the fund, accompanied by deferred cash compensation and clawbacks. This means that in the future managers will likely need to do a better job of aligning their compensation arrangements with the objectives of their investors.

Selection criteria and redemptions Hedge fund managers believe that historic long- and short-term performances are two of the top criteria that investors use to select a manager. However, the survey results show that investors identify the investment team (82 percent), risk management (70 percent) and investment philosophy (66 percent) as the three most important initial screening criteria. This suggests that during initial selection, confidence that managers can generate strong future returns is more important to investors than actual past performance.

Managers overwhelmingly (86 percent) cite performance as the primary reason for redemptions, but while investors (86 percent) also see this as important, they are almost equally inclined (84 percent) to take their assets elsewhere when there are changes in key personnel. This shows that the fund industry remains a "people" business. Cataldo Castagna, Partner, Financial Services, Ernst & Young Switzerland, says: «Staff turnover is a communication issue for hedge funds. Managers that communicate openly and honestly with investors about changes in the team and performance could create the necessary confidence in future returns to keep investors from pulling out of the fund».

Capital investments, fees and expenses To support asset growth and the implementation of new strategies, nearly two in three hedge funds have either added headcount in the front office or expect to in the near future. Additionally, almost 45 percent of hedge funds are adding headcount in support functions - middle-office, back-office, risk management, and legal and compliance - to support expected growth, client demands for transparency and increased regulatory requirements. Moreover, over half of managers are making technology investments in risk management, compliance, and portfolio management systems. Investors generally welcome these outlays; two-thirds of investors say that their managers need to invest in risk management technology, and nearly 60 percent say their managers need to spend on investment management systems.

However, while investors are demanding more transparency from hedge fund managers, they also expect hedge funds to cover the costs. More than two-thirds of managers pass on the cost of D&O insurance, as well as regulatory registration and compliance for the fund. However, over half of investors say it is unacceptable for managers to pass through the cost of D&O insurance, and about half say it is unacceptable for the costs of regulation to be passed on to the fund.

«There is still a disparity between the costs typically picked up by the funds and the costs that investors think they should cover», notes Cataldo Castagna. «However, we welcome the trend that greater alignment with regard to who must bear the costs is taking place».

Evolving funds of funds business model Investor support for emerging and start-up funds is increasing. This is being accompanied by a squeeze on margins, most notably with funds of funds. These are demanding and getting a variety of concessions from fund managers, particularly on fees (95 percent), and often in return for larger mandates (83 percent) and lock-ups (56 percent). «This flies in the face of conventional wisdom that the largest managers are gathering all the assets. More particularly, a significant majority of funds say that they are investing in a "fund of one." Both these trends attest to an industry that is thriving again and continually reinvigorating. It is difficult to assess whether there is a causal relationship between this trend and a squeeze on margins, but there appears to be conclusive evidence that in each case, funds of funds, as investors, are demanding, and getting, a variety of concessions from fund managers,» says Christian Soguel.

Requirements for the boards of trustees of Swiss pension funds to increase «If pension funds in Switzerland decide to invest in single hedge fund types instead of diversified fund of funds to achieve more targeted risk adjusted returns for their overall portfolio, then the boards of trustees of Swiss pension funds are likely to need additional know-how with regard to selecting strategies and monitoring hedge funds. Over the long term, such an investment in "education" is likely to bear fruit for hedge fund providers», according to Cataldo Castagna.

Contact:

Simone Isermann
Ernst & Young
Media Relations
Phone: +41 (0) 58 286 35 97
simone.isermann@ch.ey.com

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