Paladyne Systems : Technology Solutions for Hedge Funds » scalder

Hedge Fund Fees – Is the Party Over? by Stuart Calder

scalder — Wed, 01 Dec 2010 17:08:08 +0000

The topic of fees charged by money managers is back in the spotlight thanks to a new management company called FundSmith being set up in London by Terry Smith. Mr Smith is a veteran of the financial scene, but his track record is more in brokerage, and this is his first venture into fund management.

Terry Smith is one of those characters whose name is normally prefixed with words like ‘maverick’ or ‘combative’, and he freely admits that he enjoys a good argument. He is openly challenging both the fee levels charged by the asset management industry, and also the amount of trading (some would say ‘churning’) that managers engage in as they try to appear ‘active’.

An admirer of Warren Buffet, Mr Smith is advocating long-term, low-turnover investing based on fundamentals, and promises lower fees at least in part thanks to lower brokerage costs, because the fund will trade infrequently, and invest in only ’20 to 30’ stocks.

Although FundSmith is not a hedge fund, Mr Smith has been especially critical of Hedge Fund fees.

So can hedge fund fees really be justified, and will they come under pressure thanks to lower cost approach of the likes of FundSmith spreading to the alternate sector?

The classic hedge fund fee structure is ‘2 and 20’. The manager takes 2% as a management fee, no matter what, and takes a further 20% of any gains (after the management fee has been deducted) as a performance or incentive fee.

It’s not quite that simple, as there will typically be high water marks in place to protect the investor from being charged twice if the manager makes money, then loses it, then makes it back again. There may also be a hurdle rate that the manager has to exceed before charging a performance fee.

Nevertheless, the fees charged to investors can be substantial. Back in the pre-crisis days of 2007, the UK manager GLG Partners (now part of Man Group) reported performance fees of $341 Million in a single quarter, while managing $21 Billion in assets – and that excludes the management fee, not to mention commissions and fees paid for execution and research.

Of course hedge fund managers see nothing to apologize for, and will argue that performance fees are exactly that – a reward for skill that is denied to the unsuccessful. Investors are very quick to redeem money from underperforming funds.

Unlike FundSmith, many hedge fund strategies are not based on participation in wealth creation at all, and nor do they pretend otherwise. Short selling, high-frequency trading, various arbitrages – all just rely on wealth redistribution in favour of the manager, and are necessarily minority sports. If they are not illegal, and can outperform traditional managers even after fees are taken into account, then where is the problem?

Nevertheless, it is possible to see merit in the broad argument that investors are simply conditioned to paying high fees and dealing costs because no viable alternative has been on offer from an industry with self-interest at its heart.

Perhaps FundSmith will, by breaking ranks in this way, come to be seen as a turning point on the road to a leaner, less complacent investment industry.

European Regulators Closing in on Hedge Funds by Stuart Calder

scalder — Wed, 23 Jun 2010 22:26:39 +0000

European politicians have long been hostile to hedge funds. In 2007, the German Vice Chancellor Franz Müntefering famously branded them ‘financial locusts’. Prior to his election, French President Nicolas Sarkozy described them as “predators” that “create zero wealth,” and proposed punitive taxes on ‘speculative’ transactions.

Their objections are probably rooted in the fact that hedge fund activities are perceived as largely unregulated, and therefore outside the control of politicians and bureaucrats. The fact that 80% of European hedge funds are based in London, not Paris or Frankfurt, has only added to their antipathy.

The financial crisis that took hold in 2008 gave these politicians the perfect opportunity for a regulatory crackdown, with hedge funds a convenient scapegoat – even though several studies have concluded that banks, not hedge funds, were most guilty of excessive leverage and risk.

The result was AIFM – the proposed directive on Alternative Investment Fund Managers. The wheels of European regulation grind slowly, but finally we are approaching the stage where legislation may be enacted – although even now there are complications: two separate drafts of the directive have been proposed by the European Parliament and the European Council, and they are now trying to come up with a single version.

Under the AIFM proposals, hedge funds managers based in EU countries would be subject to quite onerous new capital and reporting requirements. The rules are based on the domicile of the managers, so basing the funds themselves in Cayman or other offshore havens provides no exemption.

What is more, the ripples will be felt much more widely, because managers from ‘3^rd Countries’ outside the EU, which includes USA, are supposed to comply with certain provisions before they can market themselves to EU investors. US Treasury Secretary Geithner has been forceful in expressing his concerns, and some watering down seems likely.

Some hedge fund managers have looked to avoid the AIFM provisions by offering their hedge funds under a regulated UCITS structure – the so-called ‘NewCITS’ approach that was supposed to provide hedge fund returns, but with higher levels investor protection.

However, the consensus is that NewCITS funds have yet to be stress-tested, and many doubt their ability to deliver on the investor liquidity requirements when the going gets tough. The amount of new money they have attracted has so far fallen short of their early promise, so they are no proven silver bullet.

Either way, it seems the financial crisis has played into the hands of regulation-hungry Eurocrats. Whether this proves to be in the long-term interests of investors is another matter, as the regulations come with a significant cost burden. Singapore and other locations will be rubbing their hands.

Stuart Calder is based in the UK and is global head of product management at Paladyne. Prior to this he spent over 4 years as a Product Director at Linedata Services, where he had global responsibility for the Beauchamp suite of products that focused on the alternative investment space. Stuart has been a frequent speaker at industry events, and a regulator contributor to trade publications in the asset management space.

Benefits of Combined OMS and PMS for Hedge Funds by Stuart Calder

scalder — Wed, 24 Mar 2010 06:34:42 +0000

Why can HFs benefit from a combined OMS / PMS solution?

While it is a popular myth that ‘all HFs trade all the time’, it is certainly true that many do trade much more actively than institutional managers, and are also more reactive to market events.

It is also the case that in many HFs, particularly the smaller ones, there is no separation between portfolio management and order execution. The manager making the investment decision, and the trader executing that decision, are frequently one and the same person.

For these reasons, HF managers need to keep a close eye on their portfolio whilst simultaneously tracking the status of their orders and executions in the market. A tightly-integrated solution that provides a consistent, real-time view across orders, executions, and positions, and can instantly generate orders directly from positions, has clear advantages over separate systems.

Recent market trends have further underlined the case for a unified solution. Many HF managers in Europe and Asia have re-packaged their funds to be compliant with UCITS regulations in order to attract or retain investors spooked by extreme market events in 2008/2009. (Although UCITS rules were developed in Europe, there is nothing to stop managers in other locations from running their funds by the same rules.)

UCITS rules have evolved over time so they now provide flexibility to adopt HF techniques such as shorting, leverage, and use of derivatives, but within a regulatory framework that places strict limits on exposures and concentrations. These rules have helped to convince many investors that UCITS funds can provided at least some of the enhanced returns promised by HFs, while providing more explicit and transparent risk management.

Moreover, even pure HF managers are anticipating a wave of regulation resulting from the political reaction to the financial crisis – still the subject of discussion as the EU Directive on Alternative Investment Fund Managers (AIFMs) continues its formulation process.

Compliance with investment rules can be achieved much more efficiently with pre-trade checks than post-trade analysis that may only identify breaches too late, and result in expensive corrective action (though post-trade is also necessary to deal with passive breaches as valuations fluctuate); and pre-trade compliance works most effectively within an integrated solution that gives direct access to the full portfolio – otherwise it risks being too slow while it waits for information from a separate system, or the checks may be run against outdated information.

In summary, tight integration of PMS, OMS, and pre-trade compliance provides clear advantages in a real-time environment where regulation is becoming more pervasive.