Fixed vs. Variable Hedge Fund costs

Within the Hedge Fund industry Institutional Investors are putting increasing downward pressure on the fees being charged by many funds. The erosion of Performance and Management Fees has been well documented but less so the reduction they are seeking in more generic operational fees. These include the fees to staff and run a proficient operations department as well as the software to support it.

Throughout the industry there is a push away from these fixed costs to instead mandating expert service providers to provide these services. These include outsourcing of a Hedge Fund’s traditional middle office, trade processing and software support. These services are often paid for on an asset basis - the fees changing as the Funds NAV moves up and down.

This move to variable fund costs is in turn enabling Hedge Fund Managers to offer new Hedge Funds at a lower Total Expense Ratio (TER) which should be more favourably received by Institutional Investors.

This is the very start of a trend I expect to see continuing over the next few years. The best practice line between what should be kept in-house and what should be outsourced has yet to be determined.

The trend towards Liability Caps at some Hedge Fund Administrators.

An interesting new development within the Hedge Fund industry concerns the increasing use of Liability Caps by Fund Administrators. Hedge Fund Administrators particularly are starting to follow the lead set by many auditors a number of years ago and placing a cap on their potential liability within their Administration agreements in the case of incorrect NAV calculation.

The implications for this for the Investment Manager could be quite significant. Essentially they are made far more accountable for the correct valuation of the Fund’s NAV. To ensure this is done accurately will require significant investment in adequate operational systems, resources and controls.

And this goes back to another point I’d heard recently – the increasing requirement by many institutional investors to have a full separate general ledger – independent of their administrator. This is a big change because many existing “shadow” fund accounting systems are not and where not built to have this level of functionality. This is likely to increase pressure on the industries software vendors to ramp up the accounting functionality of their software.