The global hedge fund industry is starting to strut again.

A recent Deutsche Bank survey showed that institutional investors were flocking to hedge funds. Deutsche predicted the sector’s assets under management would pass the $3 trillion mark this year.

And 84% of investors in a new Preqin report said 2013 performance — up 11.1%, after a gain of 10.1% in 2012 — had met or exceeded their expectations. This was a nice turnaround from 2011, when hedge funds lost nearly 2%.

Robert Mirsky, global head of hedge funds at KPMG, recently spoke with Hedgeweek about trends he was seeing in the year ahead: hedge fund managers are focused on cost effectiveness, liquid alternatives are gaining prominence and regulation is acting as a catalyst for European hedge fund growth.

Operational Cost Efficiency

Mirsky said he and his KPMG colleagues had continued to see margins being squeezed. Fee compression was coming at a time when the cost of doing business was rising.

He pointed to KPMG’s recent global survey that put the cost of regulatory compliance at 30 to 40 basis points depending on location.

“If 25% of the management fee is being taken up with regulatory compliance, it’s clear to see just how much operating margins are being squeezed,” he said.

Mirsky said managers faced with lower operating revenues were striving to run their businesses more cost-effectively through increased use of new technology, particularly cloud-based technology, and willingness to outsource non-core functions, a trend he expected would continue in 2014.

He contrasted the desire among managers in recent years to spread counterparty risk by using multiple prime brokers with another emerging trend.

“What’s interesting is that now we are seeing managers choosing to use one key service provider to handle a variety of services from prime brokerage to custodial services to fund administration.”

He said many universal banks were well positioned to provide these services, and to do so without increasing counterparty risk because the services tended to be separate legal entities within the holding company with Chinese walls separating their activities.

Indeed, this is now becoming a core part of certain universal banks’ business strategy, Mirsky said. Like the managers, bank institutions that support them also face increased revenue pressures because of capital restrictions under new regulations.

Giving managers access to the whole banking platform is good for both parties, he said. It also has the potential to keep cost to a minimum for the manager because all of the counterparty risk is centralized.

“There are innovative ways of dealing with rising costs,” Mirsky said. “If you aren’t looking to outsource as a smaller manager, you won’t survive.”

The figures explain why. Mirsky put the average break-even size of today’s hedge fund at $150 million, but said a huge number were running with less than $100 million in assets under management.

“They survive because they are actively dealing with these costs.”

Regulation Trends

Mirsky expected managers to continue focusing their efforts on regulation. “The cost of regulation under the Foreign Account Tax Compliance Act, the Alternative Investment Fund Managers Directive, SEC/CFTC etc. has been very high not just in dollar terms but the amount of management time taken up.”

But he was starting to see a light at the end of the tunnel, at least for Europe-based managers in respect to the AIFMD.

The AIFMD goes into full effect in July, and by September, Mirsky said, “managers will start focusing once again on growing the business.”

Indeed, regulation could prompt managers to offer regulated products as an alternative to traditional offshore products: either as listed funds, alternative UCITS or ’40 Act funds, he said.

He said that interest in raising European assets was starting to return, and that Europe would become an important source of capital again in the next 12 months.

“I think managers would be remiss to overlook the investor opportunities in Europe, maybe not right now but certainly in the next six to 12 months.”

Liquid Alternatives

Mirsky said demand for liquid alternatives was part of the regulation narrative. Alternative mutual funds — liquid alternatives — have been gaining prominence in the U.S. as hedge fund managers have had to register with the SEC as investment advisors.

Mutual fund houses as well as private equity and hedge fund managers have been pumping out single and multimanager 40 Act funds to tap into a huge reserve of regulated assets.

“We expect to see more interest in 40 Act funds toward the end of this year and into 2015,” Mirsky said. “However, managers need to be aware of the fact that these fund vehicles are not cheap to set up; it’s an expensive proposition.”

But the incentive is huge. It opens up the manager to a massive investor base.

“The 401(k) plan in the U.S. is the Holy Grail,” he said. “Getting an alternative mutual fund into a retirement product suite is something every manager would want.”

However, Mirsky cautioned managers not to cannibalize their main product line, their offshore flagship hedge fund, by launching something ostensibly the same.

“It is and should be considered a different kind of product, one that is better suited to the regulated marketplace.”