As the hedge fund industry matures, managers who survived the financial crisis are now beginning to focus on growing beyond their original business models, according to EY’s seventh annual survey of the global hedge fund market, Exploring pathways to growth.

However, the survey shows that while managers want to grow their assets under management through new products and distribution channels, investors do not necessarily plan to increase allocations to hedge funds and are not interested in buying multiple products from one manager.

The 2013 global survey compares opinions from 100 hedge fund managers who collectively manage nearly US$850 billion and 65 institutional investors with over US$190 billion allocated to hedge funds. Topics covered in the survey include strategic priorities for hedge funds, changes in revenues and costs, technology, headcount, outsourcing and shadowing, and the future of the hedge fund industry.

Art Tully, co-leader, Global Hedge Fund Services, EY, says: "Managers are investing heavily to promote growth, expanding into new strategies and products such as institutional long-only offerings and registered funds. They are also devoting more resources to operational infrastructure in order to scale that growth. The largest managers are making the bulk of these investments, and for now they appear to be reaping the rewards, attracting the majority of the industry inflows. But, the growth ambitions of managers may not be matched by sustained investor appetite."

Managers more bullish about growth than investors

Managers are optimistic about their growth prospects. In addition to investing in new strategies and products, managers are developing distribution networks and channels in which they have traditionally not been engaged. However, their optimism is not shared by investors.

A majority of investors (72%) say that they expect to maintain current allocation levels, while managers, particularly smaller managers, remain bullish about both inflows and market appreciation – managers with less than US$10 billion under management are budgeting for 15% growth in 2013.

Michael Serota, co-leader, EY’s Global Hedge Fund Services, says: "While managers seem determined to diversify their offerings, investors are much less interested in buying multiple products from the same manager. Instead, they seek the best type of manager for particular strategies. This explains why managers attract money from new clients at almost the same rate as they do from existing clients."

Battle to maintain margins, as cost increases outpace revenue growth

As investor and regulatory demands grow, managers are focusing relentlessly on operational efficiency and costs in the battle to maintain margins.

According to the survey, two in three managers reported an increase in revenues over the past year as performance improved and assets grew. However, just half of managers reported improvements in margins. One in three managers said margins declined and another 10% noted margins remained unchanged as costs increased.

Julian Young, leader, EY’s Europe, Middle East, India and Africa Hedge Funds, says: "European managers appear to have a tight control over their costs and anticipate the greatest increase in margins. This is probably because they are managing costs by outsourcing, refraining from shadowing and offering less complex strategies."

Just one in three European managers noted that costs have increased versus 58% in North America. Although three in four managers in Asia said that costs had increased, they have also been the most successful in raising capital and thereby growing revenue, and margins have improved as a result.

Managers attribute increased costs to developing infrastructure to meet demands of regulatory reporting, upgrading technology and scaling the business to service growing assets. To date, regulations have primarily served to add costs to the system — costs that are being borne by investors and managers, but have provided minimal benefit to the due diligence process or to minimize any concerns of systemic risk.

In fact, over two-thirds of investors say that regulations have had no impact on their due diligence process for vetting investments. Investors and managers are more aligned than in the past in their expectations for the future. Both expect increasing regulatory intrusions and accompanying costs.

The cost of shadowing is significant. Hedge funds fully shadow across a range of functions to mitigate the risk of error, and indirectly to provide a contingency plan, if needed. They shadow more in the front office, where sensitivities to error are greatest and timely resolution of errors is critical to avert adverse consequence and reputational risk. It is not surprising that the survey highlights that the majority of hedge fund managers continue to fully shadow.

What is surprising is that a growing percent of managers have developed stronger relationships with fund administrators and are paring down full shadows, granting partial oversight to the fund administrator.

Investors agree that the front office is most important, but are more discriminating than managers in what they deem important to shadow.

Trade reconciliation and investment valuation are most important, while a number of back-office functions, including partner/shareholder accounting and investor reporting are not. Yet, nearly half of hedge funds fully shadow these latter functions.

When asked what conditions are needed to reduce shadowing, some managers cited a higher level of integration with their administrators. Others admit that they would need agreement among all their investors that they could stop.

Polarity between large and small managers increases

Increased polarization in the industry is more evident than ever, with the largest funds succeeding because of their size and scale and their ability and willingness to invest in the business, and the smallest by virtue of simplicity.

In particular, the largest and smallest managers have the most efficient headcount ratios between front-office and back-office personnel – the largest because they have been able to achieve economies of scale and the smallest because they cannot afford to be inefficient.

Serota added: "Fewer managers than in 2012 said they plan on adding headcount across front and back office functions – a sign that the pace of hiring is slowing. However, the largest managers continue to add headcount at a faster rate than the overall market in virtually every function, including marketing, investment operations, risk management and legal/compliance, to ensure their operating models are adequate and scalable to support growth and meet the expectations of investors and consultants."

North America leads Europe in offering more customized solutions

There is a growing demand for customized solutions, and that demand is clearly being met. Nearly two-thirds of investors either already invest or would like to invest in a customized product. Demand is most evident among funds of funds, with nearly 70% of funds of funds surveyed already invested in a customized solution and another 15% saying they would like to.

However, there are some geographical differences, as 75% of managers in North America offer customized solutions or plan to, compared with just 50% of managers in Europe.

Tully added: "Hedge fund managers that can offer the best customized solutions at a competitive price and those that can say ‘no’ will be most successful in the long term. Right now, the largest managers appear to be winning – they can offer customized solutions at the lowest marginal cost."

Shift to direct investment

More than 75% of hedge fund managers in Europe and North America say that direct investment has increased and most expect this trend to continue.

"Direct investment continues to increase and is preferred by managers, with intermediation shifting away from funds of funds to investment consultants," said Serota. "As such, some funds of funds are offering more advisory-like services in order to compete. With returns likely to remain subdued and investors finding access easier, there will remain a focus on the costs of intermediation."

An increasing proportion of managers expect that they will work with investment consultants in the coming years, which has meaningful implications for managers’ marketing strategies and service models.

Funds of funds are responding by seeking out newer, smaller, managers, seeking greater concessions from them and being able to present smaller institutional investors with a package that is still saleable.