So much for Dodd-Frank: A survey of institutional investors by auditing and consulting firm Ernst & Young finds that most don’t think increased regulation of hedge funds will make much of a difference.
Just 10 percent of investors think regulations effectively protect their interests. What’s more, just 2 percent think regulations will be effective at preventing the next crisis. And fully 85 percent of investors do not think these kinds of requirements will help prevent the next financial crisis. This compares with 2010, when 41 percent of those who participated in a similar survey said regulations effectively protect their interests.
These findings are part of Ernst & Young’s sixth annual survey of the global hedge fund market, which was compiled by consulting firm Greenwich Associates. Greenwich surveyed 100 hedge fund managers who collectively run over $710 billion and 50 institutional investors with over $190 billion combined allocated to hedge funds.
“Our survey findings suggest that hedge fund regulations are not beneficial to investors, who overwhelmingly question their purpose and proliferation,” says Ratan Engineer, global leader of Ernst & Young’s Asset Management practice, in a press release. E&Y officials were not available to comment directly.
He recommends that hedge fund managers press regulators to focus on issues that result in financial stability rather than introduce more costly or unnecessary requirements that investors feel are of little value.
This is an interesting concept. After all, the SEC’s mission is to look out for the investor, in many cases the poor, defenseless individual investor.
Only sophisticated investors can access hedge funds, so the investors in this case are most likely multi-millionaires or institutional investor. The survey only questioned 50 large institutions, however. It did not ask how less affluent individuals who meet the accredited investor requirement feel about regulation.
This is important. Less affluent accredited investors may prefer more regulation, especially since they are more likely to be the ones who invest in the much smaller, lesser known firms with skimpy compliance departments.
Of course, you can understand why managers are discrediting the value of regulations. In the report nearly half of hedge fund managers complained about the rising cost of doing business in general. More than half of the managers are spending more money on technology dedicated to risk management, compliance and investment management systems.
Investors, however, think this is a good idea. For example, in the survey two-thirds of investors said managers need to invest in risk management technology while nearly 60 percent said managers need to spend money on investment management systems.
Not surprisingly, investors expect the hedge funds to pick up the tab for these costs. But it does not always work this way. A majority of managers said they were able to pass on certain costs to the fund, meaning that investors ultimately foot the bill.
For example, 70 percent pass on the cost of directors and officers insurance to the funds, up from 60 percent in 2011. In addition, 68 percent said they pass on regulatory registration and compliance costs to the fund, exactly double the number of managers who did so just a year ago. Another 47 percent said they pass on non travel expenses.
Investors, however, disagree with these practices. For example, they were asked which expenses should be covered by the management fees – in other words, not passed on to the fund. D&O Insurance was cited by 58 percent of investors, way up from 33 percent who felt this way just a year ago. Another 46 percent said regulatory registration and compliance costs should not be passed on.
However, investors were even more emphatic about other expenses. For example, between 76 percent and 82 percent of investors said the following costs should come out of the management fee rather than get passed on to them: research-related travel, regulatory exams, costs of shadow accounting/processing, marketing expenses, trader compensation.
Meanwhile, there is a big disconnect between managers and investors when it comes to compensation. For example, 87 percent of managers currently believe risk and performance are effectively aligned with investor objectives. This is down, however, from 94 percent who felt this way in E&Y’s 2010 survey. However, today just 42 percent of investors agree with this notion, and this is down from 50 percent two years ago.
Perhaps more significantly, nearly three-quarters of senior executives’ compensation is paid in cash—same as two years ago. Trouble is, investors want less than 40 percent of compensation to be paid in cash, with a large chunk paid in equity and deferred cash (three years or more) and subject to clawbacks.
With the average hedge fund eking out a low single-digit return this year after losing money last year, according to industry tracker Hedge Fund Research, the tension over compensation is most likely going to intensify next year.