How to overcome the drag on funds

How to overcome the drag on funds

In the immediate aftermath of the financial crisis, then US treasury secretary Henry Paulson said there was a very real threat of regulation becoming "a wolf in sheep's clothing". A decade on, and regulation unquestionably remains a highly sensitive issue. Those immersed in the markets continue to battle for less of it, while the man on the street demands more.

One thing is for certain: no rule maker foresaw a direct cost to investor returns. Unfortunately, unintended consequences of certain regulations have done just that. As a case in point, hedge fund managers can now be charged a staggering 70 per cent additional margin because of certain compliance changes, destroying returns for their investors. Specific rules on clearing houses, not widely understood by the investor community, mean they are being charged what’s called a “liquidity add-on” for large positions – amounting to a massive drag on returns. In a world where investors continue to demand more bang for their buck, this is a significant drag on a hedge fund's returns. So why has this become such a big problem for hedge fund managers now, and, crucially, what can they do to overcome it in order to drive better returns?

To answer the first half of this question, one has to look at how regulation has overhauled market structure. Pre-crisis, if you asked a hedge fund manager about derivative margin requirements you would have received a blank look. Today, implementation of new mandatory clearing and uncleared margin requirements, such as the European Market Infrastructure Regulation (EMIR) and most recently the Markets in Financial Instruments Directive II (Mifid II), has significantly increased the cost of trading and consequently, contributed to reduced investor returns. From first quarter to fourth quarter last year, the amount of uncleared margin posted was up almost 25 per cent, according to the International Swaps and Derivatives Association. However, regulation has not been the only factor at play. Recent macro trends such as slowly rising interest rates has had an impact. As rates rise, so too does the cost of margin. If this was not enough, fund managers are in the midst of a price war on investor fees, which continue to go lower and lower. And as more flow moves into index trackers, it is also becoming harder to beat the likes of the S&P 500.

As regulatory and macro pressures mount, every basis point now counts more than ever. Old approaches to trading can now lead to major capital and cost inefficiencies. There are no longer simple rules of thumb that can be relied upon. Very similar trading alternatives can lead to doubling the cost or capital. It has, therefore, become essential for all firms to quantify alternatives before and after they trade. But this approach is not easy, as it requires a deep understanding of a complex web of models that drive cost and capital usage.

Making fund managers post more cash to guard against the next financial meltdown is all very well in principle. But in practice, it has proven to trigger an enormous cost, which ultimately, has been shouldered by the very end investors that rule makers are trying to protect. As investors understandably continue to scrutinise every penny, more firms will seek out in-depth analysis in order to reduce margin, which subsequently means that the unfortunate by-product of regulations will no longer hit the end investor in the wallet.