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Article published on August 9, 2017
By Lydia Tomkiw

 

Hedge funds are increasingly looking to shadow only core areas of their fund administrators, amid performance pressure and a hunt for ways to cut costs, industry watchers say.

While full shadowing – essentially duplicating an administrator’s functions to verify and secure fund data – remains in the market, more managers are eyeing a model of “oversight and governance,” which entails shadowing only key areas of their administrators.

“It’s a significant shift and it does reflect the evolution of the hedge fund industry and the challenges the industry is facing – and how those drivers are shifting how a hedge fund is run,” says Samer Ojjeh, a principal in the financial services organization at Ernst & Young, who co-authored a recent paper on the subject.

Approximately 90% of the managers Ojjeh works with have debated moving to an oversight and governance model, including about 40% that have taken steps such as gradually shifting away from shadowing reconciliation or trade settlement activity, he says. Part of the process involves managers doing a lot of homework around their service providers and understanding the processes and procedures when it comes to business continuity plans.

“We are seeing a significant focus on this because of the cost pressure and the fee pressure they are under. It’s not sustainable to pay for two sets of books or two sets of back offices,” he adds.

Under an oversight and governance model, managers can reduce some operating costs by outsourcing those shadowing functions to admin firms, including back-office processes such as NAV calculation, according to the paper.

The overall market has improved so far in 2017, with inflows picking up and hedge funds posting their strongest performance of the year in July, gaining 1.2%, according to Hedge Fund Research’s weighted composite index. Despite the performance turnaround halfway through 2017, investors have become increasingly averse to fund pass-through expenses, including research and travel, according to EY’s 2016 global hedge fund survey. But the highest level of respondents, at 34%, said it was acceptable for managers to pass through expenses related to outsourcing back-office shadow functions.

Managers increasingly want to spend more time focused on trading and research, which is driving them to outsource other aspects to third party providers, says David Young, president at Gemini Hedge Fund Services.

“It reduces their cost structure internally, which allows them to be much more competitive from a fee perspective,” he says. “Obviously as funds are under fee pressure… it does put on additional constraints in regards to your ability to properly staff. And by outsourcing they can get the efficiency of what an outsourced third party can provide.”

Some hedge fund managers are now even looking to hire a second fund administrator to check the work of their current admin, Young says, noting approximately 15% of Gemini’s hedge funds clients are using it for this service.

Part of the process of deciding on a correct fit when it comes to shadowing arrangements is asking the right questions, he adds. “If you’re spending money to have a shadow process, whether internal or external, do you have the right process in place? Are you assured that you’re going to come up with a true secondary check?”

While some managers are eyeing the switch, the process is more of an evolution than a revolution, moving at a slower pace, argues John Phinney, co-founder of Convergence, Inc., a firm that identifies, tracks, and reports changes across the alternatives industry on a daily basis.

Mangers face a tough decision when settling on which model is right for them, prompting a lot of talk, but not as much action, he says. Part of the problem for managers is finding the right cultural fit with their admin providers.

“The reality of the opportunity is really rooted in culture. The advisor has to be willing to give up certain [control] or they have to create a whole different level of transparency around what they are doing,” Phinney says. “So while it has interesting economic [implications]…. more people opt not to do it because they do not want to give up certain [control] they have.”

Hedge funds employing the oversight and governance model range in size from those above the $25 billion assets under management mark to start-up managers and across strategies, the EY paper found.

Hedge funds have increasingly been looking at different shadowing arrangements, says Sidney Wigfall, managing partner at SCA Compliance and Consulting. From a compliance standpoint, “delegation without abdication” is the principle that has been reinforced by the Securities and Exchange Commission, with managers needing to have oversight of key service providers, he says.

“For those firms that were doing it at a full 100% shadowing, it shouldn’t be too difficult to get to a place where they pull back and only need to do cross validation on key areas,” he says.

While questions may arise over business continuity and cybersecurity, cost pressures are likely to keep driving hedge fund managers to reevaluate their set-ups, he says. “I think you’ll see more and more firms at least revisiting their structure to see if there are cost savings they can capture.”

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