4 reasons the hedge fund industry is dead
The superstars of the next 10 years will have to come up with an entirely new firm structure.
The Economist published a piece last week about the struggles of the hedge fund industry in the first half of 2012, which hasn't improved much from 2011.
There are four structural reasons why the industry as we know it is dead.
No. 1: The incentive structure
Due to a variety of forces -- increased competition for assets, the volatility of the past decade (especially the past four years), and the lack of liquidity and transparency for hedge fund investors in 2008 -- the industry is unable to look past the current year, and in many cases, even the next two to three months.
Analysts are worried about making one bad call and getting fired. Or dreaming about getting one call right and leaving for greener pastures. Managers are worried about getting redeemed. Impatient hedge fund investors are worried about missing out on the next hot fund, or being stuck with a bad one, and in many cases have lost faith in managers who violated their trust over the past several years.
As a result, the industry judges all financial assets on the basis of their short-term merits. Over the next five to 10 years, it's likely that U.S. treasuries will underperform U.S. equities, and high-dividend stocks in the consumer and utility sectors that have recently outperformed and are relatively expensive will underperform many growth and cyclical names. Over the near term? It's anyone's guess. Hedge funds can't afford to take a shot on a company with a great five-year story that could have a hairy next quarter or two.
No. 2: The overhead
In addition to the new due diligence forms required of hedge funds by their investors, the government has piled on forms. For instance, large hedge funds registered with the SEC are required to fill out Form PF, a 42-page document, on a quarterly basis. Dotting the i's and crossing the t's has become much more critical in a post-Lehman, post-Madoff, post-MF Global world. It's a major headache for firms; it detracts from their core competency, and serves as a tax on the business model of the industry.
No. 3: The business model
Imagine you could invest in one of the following two groups. One has 20 analysts, Bloomberg terminals throughout the office, offices in New York/London/Hong Kong, a fully loaded back office and compliance divisions, major restrictions on communication including absolutely no social media, a "2 and 20" fee structure, and several billion dollars. The other has three analysts, all of whom are highly versed in tools like FRED with some programming and data expertise, fully plugged into Twitter and other forms of financial social media, and is grubstaked with $5 million of friends and family money that isn't sweating quarterly returns, with a different fee structure/partnership that gets past the year-to-year performance chasing.
Is there any reason in 2012 why the former group will outperform the latter?
Technology has leveled the playing field -- maybe not in terms of asset-raising, but in terms of performance, absolutely.
No. 4: No opportunity for unproven managers to get funded
David Einhorn started his hedge fund at age 28 with $900,000. Paul Tudor Jones started his fund in his 20s. So did Stan Druckenmiller. There used to be a way for unproven managers from non-traditional backgrounds to get "a chip and a chair," as they say in poker. Today, with the risk aversion and overhead required by big money, there isn't.
And the well of talent from big banks that used to be the hedge fund minor leagues has dried up as they've cut prop trading and junior employees. Finance, like tech, is incredibly dynamic, with new players looking to eat incumbents' lunches all the time. If the next Facebook of the investment management world can't get funded, all that means is we're left with a bunch of Yahoos and AOLs flailing away, chewing through management fees.
The problem the investment management industry faces is that the big assets want to invest in firms that already have lots of assets, a long track record, and all the compliance and internal control whistles expected of large institutions. But that's not where the alpha's going to come from in the current hedge fund model. The superstars of the next 10 years, in addition to excelling at investment management, will have to come up with an entirely new firm structure that can get past the short-termism of the present.
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The solid report comes a month after the retailer closed all of its Canadian operations.
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