Key Takeaways
- • Yale Journal on Regulation article argues that institutional investors in hedge funds face higher "fraud costs" than retail beneficiaries, leading them to over-monitor managers and inflate industry operating costs.
- • Per KPMG's 2008 survey, costs of "corporate control" (compliance, legal, finance, risk, secretarial and audit fees, excluding fund administration) were estimated at 18% of a fund's total costs in 2008.
- • KPMG's 2012 survey reported "dynamic growth" in hedge funds driven by pension funds and university endowments, with institutions now representing a clear majority of hedge fund assets under management.
- • An Ernst & Young survey of 50 large institutional investors found 87% would maintain or increase hedge fund allocations, and ranked "risk management policies" above "long-term investment performance" as a screening criterion.
- • The article contends that monitoring costs may exceed the real cost of fraud to retail investors, representing an agency cost of institutional investing.
Summary
A Yale Journal on Regulation article examines whether hedge funds are spending too much to prevent fraud as the industry has institutionalized. The article's central thesis is that because institutional investment managers put their reputations at risk through their allocation decisions, they face higher "fraud costs" than the retail investors whose money they manage. This asymmetry gives institutional managers an incentive to over-monitor hedge fund investments, with monitoring expenditures likely far exceeding the real expected loss from fraud to ordinary retail beneficiaries.
The article draws on industry surveys to document rising operating costs. According to KPMG's 2008 Hedge Fund Cost Survey, the proportion of costs devoted to corporate control rose significantly when a fund managed mostly institutional money, and was estimated at 18% of total fund costs that year. KPMG's 2012 survey, as cited by the article, described "dynamic growth" fueled by pension funds and university endowments. An Ernst & Young survey of 50 of the largest global institutional investors found 87% planned to maintain or increase hedge fund allocations, and that these investors continued to rank risk management policies above long-term performance when selecting managers. Managers reported that time spent on due diligence inquiries had doubled since 2008, and roughly 40% to 45% of hedge funds were adding support-function headcount.
The author argues that the growing layering of principal-agent relationships compounds the problem. Retail investors allocate through pensions or other institutions, which in turn delegate to hedge fund managers, leaving the ultimate beneficiaries with no role in negotiating audit, custodial, or administrative arrangements. Monitoring in hedge funds is largely voluntary, as the industry is lightly regulated, and these costs are charged to fund expenses, directly reducing returns.
The article also identifies a regulatory explanation: Section 205(a)(1) of the Investment Advisers Act of 1940 restricts registered advisers' use of performance fees, so institutional managers are compensated only through management fees and may be more risk-averse than their investors. The article notes the data on hedge fund fraud is too scarce to precisely estimate fraud costs, so its conclusion rests largely on incentive-structure analysis. Note that this is a 2016 commentary; the surveys cited date from 2008 to 2012.
The article draws on industry surveys to document rising operating costs. According to KPMG's 2008 Hedge Fund Cost Survey, the proportion of costs devoted to corporate control rose significantly when a fund managed mostly institutional money, and was estimated at 18% of total fund costs that year. KPMG's 2012 survey, as cited by the article, described "dynamic growth" fueled by pension funds and university endowments. An Ernst & Young survey of 50 of the largest global institutional investors found 87% planned to maintain or increase hedge fund allocations, and that these investors continued to rank risk management policies above long-term performance when selecting managers. Managers reported that time spent on due diligence inquiries had doubled since 2008, and roughly 40% to 45% of hedge funds were adding support-function headcount.
The author argues that the growing layering of principal-agent relationships compounds the problem. Retail investors allocate through pensions or other institutions, which in turn delegate to hedge fund managers, leaving the ultimate beneficiaries with no role in negotiating audit, custodial, or administrative arrangements. Monitoring in hedge funds is largely voluntary, as the industry is lightly regulated, and these costs are charged to fund expenses, directly reducing returns.
The article also identifies a regulatory explanation: Section 205(a)(1) of the Investment Advisers Act of 1940 restricts registered advisers' use of performance fees, so institutional managers are compensated only through management fees and may be more risk-averse than their investors. The article notes the data on hedge fund fraud is too scarce to precisely estimate fraud costs, so its conclusion rests largely on incentive-structure analysis. Note that this is a 2016 commentary; the surveys cited date from 2008 to 2012.
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