NEW YORK, Nov. 5, 2012 /PRNewswire/ -- Despite increasing regulatory requirements for hedge funds, only 10% of investors feel that regulations effectively protect their interests, and 85% of investors do not believe these requirements will help prevent the next financial crisis, according to Ernst & Young's sixth annual survey of the global hedge fund market, Finding Common Ground.

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The 2012 survey, compiled by consulting firm Greenwich Associates for Ernst & Young, compares opinions from 100 hedge fund managers who manage over US$710 billion and 50 institutional investors with over US$190 billion allocated to hedge funds on current topics related to the hedge fund industry. Findings show that although the two groups agree on increasing investments in headcount, technology and risk management, stark contrasts exist on compensation structure, fees and expenses.

Ratan Engineer, global leader of Ernst & Young's Asset Management practice, says: "Our survey findings suggest that hedge fund regulations are not beneficial to investors, who overwhelmingly question their purpose and proliferation. It may still be worthwhile for hedge fund managers to constructively engage 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."

Key findings from the report include:

Regulatory compliance
Managers will need to commit time and resources to understanding and complying with various regulatory requirements. Managers are already seeing regulations increasing their costs in prompting upgrades of compliance functions (34%) and technology dedicated to reporting (17%). Although investors expect these additional compliance costs, they fear these expenses will be passed on to the funds.

Arthur Tully, co-leader of Ernst & Young's Global Hedge Funds practice, 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 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 align with risk and performance. In many ways, they are drifting further apart.

In 2010, 94% of managers felt risk and performance were effectively aligned with investor objectives, while 50% of investors felt the same, according to Restoring the Balance, Ernst & Young's 2010 survey of the global hedge fund market. In 2012, 87% of managers feel this is true, while only 42% of investors agree. In addition, more than two-thirds of managers say that their compensation structure has not changed in the past three years – just 14% say that less is paid in cash, and just 10% say that compensation is subject to longer deferral periods. Investors, by contrast, say less than 40% 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, but the fact that it shows no sign of narrowing may become troublesome. However, this dissonance has not caused material redemptions, nor do investors cite it as a key consideration for choosing a fund.

Engineer says: "Investors clearly prefer greater use of equity in both the management company and funds, accompanied by deferrals and clawbacks. Managers may need to do a better job aligning their compensation arrangements with the objectives of their investors."

Selection criteria and redemptions
Performance will always be a key consideration for investors when selecting a fund manager, but it is not necessarily a barrier to investing. 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%), risk management (70%) and investment philosophy (66%) 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%) cite performance as the primary reason for redemptions, but while investors (86%) also see this as important, they are almost equally inclined (84%) to take their assets elsewhere when there are changes in key personnel. This shows that the industry remains, emphatically, a "people" business.

Tully says: "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."

Capital investments, fees and expenses
To support asset growth and expansion of new strategies, nearly two in three hedge funds have either added headcount in the front office or expect to in the near future. A number of hedge fund managers say hiring has been opportunistic, particularly given the upheaval at banks. Additionally, almost 45% of hedge funds are adding headcount in support functions – middle-office, back-office, risk management and legal/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 investment management systems. Investors generally agree with these outlays. Two-thirds of investors say that their managers need to invest in risk management technology, and nearly 60% 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.

Managers and investors also disagree on who should pay for functions like shadowing. While nearly 90% of hedge funds perform shadowing, and nearly all investors believe shadowing is critical to accurate valuation and reporting, only half of investors feel shadowing is worth the potential costs being passed to the funds.

"There is still a disparity between the costs typically picked up by the funds and the costs that investors think they should cover," notes Tully. "However, we are encouraged to see greater alignment with regard to investments and where they should be made within the fund."

Evolving funds of funds business model
Investor support for emerging and start-up funds is increasing. But, there is an accompanying squeeze on margins, most notably from funds of funds, who are demanding and getting a variety of concessions from fund managers, particularly on fees (95%), and often in return for larger mandates (83%) and lock-ups (56%).

Engineer concludes: "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 a thriving and continually reinvigorating industry. 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."

About the survey
Greenwich Associates, a global research and consulting firm, interviewed 100 hedge funds representing over US$710 billion in assets under management, and the views of 50 institutional investors representing over US$715 billion in assets under management. The objective of the study was to record the views and opinions of hedge funds and hedge fund investors globally, measure the views of each on the same topics and examine the two groups together. Hedge funds and hedge fund investors were asked to comment on investor demand and hedge fund selection; headcount, infrastructure and costs; administration; Euro-zone considerations; regulations and reporting; compensation structure; and the future landscape. For the full survey report, please visit www.ey.com/hedgefundsurvey

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