Hedge Funds Rebound Amid Calls for Greater Transparency

NEW YORK, Nov. 9, 2010 /PRNewswire/ -- The global hedge fund industry has largely rebounded from the financial crisis and is responding readily to investor requests for greater transparency, according to a new report published today by Ernst & Young.

Investors expect greater transparency, and agree with most hedge fund managers that the impact of new government regulations will reshape the future of the hedge fund industry, the study reveals. However, investors and managers both feel that enhanced regulations will not be overly beneficial.

The findings in the report, Restoring the Balance, were compiled by international research-based consulting firm Greenwich Associates for Ernst & Young. The annual study polled 104 hedge fund managers who manage some US$585 billion in assets, and for the first time, 53 institutional investors representing US$260 billion in assets, more than one-quarter of which are invested in hedge funds. The report highlights the juxtaposition of investors' views with those of hedge fund managers, including instances where gaps exist between the two, as well as the areas of broad agreement.

"Hedge funds have recovered sharply from the severe downturn in 2008," says Ratan Engineer, global leader of Ernst & Young's Asset Management practice. "The rebound in 2009 was dramatic, and while 2010 may provide less spectacular gains, hedge funds no longer stand at the edge of an abyss. The challenge going forward will be to satisfy investor demands while attracting and retaining talent, and to remain nimble enough to evolve in the face of new regulations, whatever form they might take. We hope the views expressed in the report will stimulate constructive debate – not just between investors and hedge fund managers but throughout the financial community."

Changes in structures, fees and liquidity terms

Many investors are putting pressure on hedge funds to lower fees and offer more favorable liquidity terms. More than half say that they have more negotiating power now, and more than 40% say that they have pressured their hedge fund managers to lower management and incentive fees. One in three institutional investors says they require greater liquidity than before the pivotal month of September 2008, and three in ten say the maximum lock-up and the maximum gate they will accept is less than it was before the crisis hit.

Of the large proportion of investors affected by liquidity restrictions, just fewer than half (48%) say that they are less likely to invest in a hedge fund that employed strategies to limit redemptions. In contrast, as many as 75% of hedge fund managers believe that investors are less likely to invest with managers who did limit redemptions.

"These results suggest that investors may be far more sophisticated and knowledgeable about the products in which they invest than managers generally believe," says Arthur Tully, co-leader of Ernst & Young's Global Hedge Funds practice.

Nearly half the funds that imposed restrictions in the crisis have now lifted them. Managers of larger funds, who were more likely to have imposed the restrictions, were the first to lift them, with more than two-thirds saying they have done so. Although some managers lost assets after lifting such restrictions, a significant portion did not. European investors were more likely to exit than investors in the US, and funds of funds were far more likely to terminate a mandate than endowments or foundations.

The global hedge fund industry has also seen dramatic structural changes to fund offerings as managers respond to investor demand. Nearly 45% of hedge funds have made changes to fees, liquidity or structure in order to attract new capital. More hedge funds in the US and Europe – 51% and 43% respectively – made changes than did those in Asia (24%). In order to attract capital, many hedge funds have adjusted liquidity terms – 36% allow liquidity more often, and 27% have reduced the minimum lock-up. In addition, nearly one in three funds has lowered management fees, but fewer (16%) say they have reduced incentive fees.

More than half of hedge fund managers say they offer or are considering offering SMAs as a strategy to attract institutional capital. However, only about 10% of investors say that SMAs are among the most appealing offerings hedge funds are using to gain a larger commitment from investors. To investors, increased reporting transparency and graduated fees are both more appealing.

"Hedge fund managers have been looking for ways to attract larger institutional mandates and increase the size of their client mandates, but there seems to be a fundamental gap in communications between hedge fund managers and investors," says Tully. "Although SMA structures can offer the transparency investors seek, it is not a panacea and it comes with several key drawbacks for the manager, including increasing the operational burden and limiting some investment strategies. Addressing the root issue of transparency is likely to be more productive."

Hedge fund managers and investors agree that long-term investment performance is the key criterion during the manager selection process. However, striking gaps do exist between the criteria hedge fund managers are marketing and those that investors say matter most. Of the managers, 37% believe a hedge fund's reputation is a key factor; 35% believe recent performance is critical. But just 11% and 15% of investors, respectively, count these criteria among their top three. By contrast, half the investors say clarity and consistency of investment philosophy is a key criterion when selecting a fund manager.

Compensation structures and transparency

Nearly two-thirds of investors say that a hedge fund's model for compensating employees is important in selecting a hedge fund. However, a striking gap is evident between manager and investor perceptions on how well current compensation structures align the risk and performance of individual managers with investor objectives. Nearly 95% of hedge fund managers believe that their compensation model effectively aligns risk-taking and performance of individual managers and traders with investors' interests. But only half of investors agree, and more than 20% say that incentives are not well aligned at all.

Hedge funds have become more transparent in their reporting to investors in the wake of the financial crisis, providing a wide spectrum of information about performance and risk. Nearly 75% of hedge funds say their investors receive all the information they would like.

Investors rank the three most important pieces of information they need from managers as performance information (38%), risk information (25%) and transparency of holdings (25%). When it comes to the information they need to assess risk, investors say they consider leverage (66%), largest holdings (55%) and asset classes (53%). On the other hand, managers feel that the most important risk information includes asset classes (81%), industry sector (75%) and geography (75%).

"Because there are no common standards across hedge funds for reporting of performance and risk information, a gap still exists between what hedge funds are providing and what investors appear to want," says Engineer. "Though a significant portion of hedge funds report across a spectrum of risk factors, not all do. Some investors are asking for information that is already available from a majority of hedge funds, while others want full position transparency. This is an area where closer cooperation might yield information of better quality and potentially reduce the blizzard of data."

Future trends

Both investors and managers believe that there will be significant regulatory intrusions, but the majority of both groups do not believe that these will be beneficial. Nearly half of hedge funds feel that new regulations stemming from broader financial reform will not be beneficial to investors over the long-term; just 16% believe they will be. Investors agree, with fewer than half of them saying that they expect the impending wave of regulation to benefit them; more than 20% of investors feel that regulation will not be beneficial.

"Impending regulation and the consequences of increased regulation are first and foremost items on hedge fund managers' minds," comments Tully. "They foresee increased costs of regulatory compliance and investments in infrastructure and technology as inevitable. These concerns stand in stark contrast to the issues hedge fund managers foresaw in 2007, when attracting and retaining talent and managing the growth in the business topped the list."

For the full report, please visit http://www.ey.com/GL/en/Industries/Asset-Management.

About the survey

Greenwich Associated interviewed 104 hedge funds representing US$585 billion in assets under management, and for the first time, the views of 53 institutional investors representing US$260 billion in assets under management, more than a quarter of which are invested in hedge funds, on behalf of Ernst & Young. 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 fund demographics and performance; fund structure; fees and liquidity terms; compensation structure; succession planning; performance; risk management and reporting; investor selection criteria; and the future landscape.

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