Following the financial crisis, the hedge fund industry is reinventing itself. Market reversals and substantial reductions in assets under management have forced fully 12% of funds to close their doors (Hedge Fund Research). High-profile scandals and accusations of impropriety have driven hedge funds to offer transparency as a competitive advantage. And the prospect of new regulations in multiple jurisdictions around the globe means that hedge funds are bracing themselves for substantially increased requirements for compliance and reporting.
Hedge funds must maintain their focus on navigating the new financial terrain and rebuild their clients’ portfolios without letting these new demands distract them. For some years, hedge funds have concluded that the most efficient course of action is to proactively outsource the operational risks associated with these challenges to third-party administrators and custodians, leaving them to concentrate on protecting beta and acquiring alpha.

A recent paper, New Views of the Hedge Fund Industry, developed by State Street as part of its Vision series of thought-leadership reports, cites two major trends affecting the industry: a migration to third-party administration and custody services and increased regulatory oversight. The paper makes clear that these phenomena are interrelated and mutually supportive. But it does not foretell doom for an industry that has performed well on both an absolute and comparative basis for many years and throughout the financial crisis. In fact, the report concludes that the hedge fund industry faces positive long-term prospects and an increased share of institutional investor allocations. By systematically re-engineering the way that it does business, the report concludes, the hedge fund industry will likely emerge smaller, in terms of the number of funds, but eventually larger in terms of assets under management.

The move to outsource administration and custody appears to be driven by three factors: a need to increase efficiency and reduce operational risk, new demands for transparency, and regulatory initiatives that may effectively force large firms to outsource these functions. With assets under management collapsing from $1.9 trillion to $1.4 trillion in 2008, according to Hedge Fund Research, the hedge fund industry clearly faces a Darwinian environment in which only the best performing and best managed funds will survive and thrive. This means taking a long hard look at the substantial costs associated with self-administration and deciding whether that expense delivers sufficient return on investments.

A migration to third party administration