A version of this article also appears here in ValueWalk
The good ol’ days
It was the golden age of hedge funds. Portfolio managers who are getting long in the tooth will remember it fondly: the “two and twenty” era – 2% of assets and 20% of profits. For many years this fee structure was the industry standard and limited partners (“LP”) were more than willing to pay the premium because the alpha was flowing. Hedge funds were outperforming the public markets and clients were making great returns. Times were good!
During this period hedge funds conducted extensive research on a wide range of potential investment opportunities. Funds used both internal resources (read: a bullpen full of junior analysts) and sell-side research. In addition to these resources, most funds retained independent industry consultants who regularly provided them with information about their respective fields to inform investment decisions.
When it came to the cost for all these research outlets, portfolio managers were more than willing to pay the going rate. In many cases, they were not actually bearing the costs themselves. Research fees were regularly charged to the fund meaning that they were not paid for out of the management fee – LP investors were footing the bill as a fund expense. That said, hedge funds were delivering double-digit annual returns that beat the public markets, so investors didn’t seem to mind these pass-through expenses.
But the times they were a-changin’…
After the global financial crisis, quantitative easing and the government-influenced low interest rate environment spurred on a record-setting 10-year bull run for the public markets that we are still riding today. One that hedge funds have struggled to beat.
Facing receding returns and fleeing investors, managers are resorting to revised fee structures like 1% & 10% or 0% & 15% to retain clients and attract new ones. These lighter fee structures have helped stem the tide of redeeming investors but they are affecting managers’ bottom lines, and as a result their research budgets. Gone were the days of charging the fund for research expenses. Savvy institutional investors now keep a close eye on with spending of their investment managers and ensure that portfolio managers bear the cost of their research via their management fees.
Without the healthy cash flows of yesteryear, managers can no longer to support large outlays on external research. To add to their headache, compliance has become a huge liability for managers. In the wake of SAC Capital shuttering as a result of industry experts passing insider information to their portfolio managers, hedge funds need better methods for protecting themselves from similar situations and staying compliant with SEC regulations.
Effective and compliant research
Today hedge fund managers face more challenges to their businesses than ever before – downward pressures on fees, increased costs of compliance and research, and a highly efficient, well-informed market. All of these factors make it difficult for managers to create alpha.
So how have they responded?
Many managers are reacting by “doing more with less.” Hedge funds on average now employ fewer analysts who are each responsible for a larger stack of projects. From there, funds are getting more concentrated. Managers spend more time on due diligence for their high conviction ideas and make fewer but larger investments, which are generally concentrated in micro and small-cap companies. These smaller companies tend to be superior avenues for finding alpha amidst the waves of passive investment capital flowing into blue chips and other large and mid-cap companies.
To support their thinly stretched internal research assets, managers continue to require the support of external resources. And now they must take great pains to ensure that it is compliant with SEC rules regarding disclosure of material non-public information (“MNPI”). Funds continue to use sell-side research and services like Bloomberg, but unlike during the “golden years” when hedge funds could acquire valuable insights over dinner and drinks with an industry executive, they use new, more formalized avenues for accessing this knowledge. Avenues that mitigate their exposure to MNPI and potential SEC violations.
Managers have turned to expert network firms to find this compliant external research support. These firms connect hedge funds with the same types of experts that they worked with in the past as informal industry consultants, but now with the legal cover of a comprehensive compliance framework. Expert networks give managers access to the outside subject matter expertise and mitigate their exposure to potential SEC rule violations.
Innovative Technology = Alpha
Despite effectively delivering access to the compliant industry insights hedge funds need, expert networks are costly options for managers. Prices generally range from $1,000 to $1,500 per engagement. When kept on retainer, expert network costs can rise into low six figures per year for a hedge fund.
Expert networks, along with sell-side research and other data services are among the many pricey research option hedge funds have to contend with in today’s market. In an effort to further reduce research costs, managers are turning more and more to self-service technology solutions to replace some of these services. Self-service technology allows funds to easily access the research they need on an a-la-carte basis and with less human interactions (read: added cost).
Moving forward, technology will be a primary driver of research cost-cutting for hedge funds and essential to their efforts to drive alpha.
Interested in learning more about how hedge funds are using Vancery to reduce their reliance on expert networks and lower their research costs?