Hedge funds future, part 1

Dear Reader,

If I told you there is an industry in which the more crowded it gets, the more expensive the industry’s products get. You would think I was ignorant. This is however what used to be the reality in the hedge fund industry. Sadly for the overpaid managers, it is not anymore.

In 2007 hedge funds around the world held over $2 trillion under management. If you account for the leverage they used the figure could be tripled. This staggering amount of money had been attracted from investors all around the world in the belief that hedge funds over a longer time period generate superior returns, also know as alpha. Hedge funds told their clients that even if returns would not be exceptionally high in good years, they would not lose money in bad years. In other words they would “hedge” their bets. Last year was a great testimony this was utter BS.

Any student studying economics learns that if supply of product X increases, the price of product X will decrease. The theory of supply and demand is the very essence of economical theory. All business and economics students know this. For some reason the alternative asset management industry seemed to defy the law of economics. How was that possible? The answer is simple, Greed.

All rational people are driven by maximising their potential gain, whether it is money or number of days off from work they can get. I know that not everyone agrees with me on this, but to explain why investors poured trillions of dollars into overpriced and poorly performing (even measured by their own industry standard) alternative asset managers one has to understand what makes people tick.

The worlds first hedge fund was created in the late 1940’s. The idea was that long positions in stocks were “hedged” by short selling other similar stocks. The manager would always make money as long as the long position did relatively better than the short position. Today hedge funds can take many different shapes and do any type of investments. Many argue their only common feature is the ridiculously high fee structure. Hedge funds charge first a fixed fee on total assets under management and on top a performance fee on profits. Typically they charge 2% on assets and 20% on profits, called 2/20. In some extreme cases a 5/44 structure was in place. The argument went that paying that much in fees would give investors superior talent. Before the crisis there were 9000 hedge funds around the globe. However, a sane person would question if there really exist 9000 people of superior talent able to make superior returns. Please bear in mind almost all funds have more than one manger. The answer is obviously no.

In a bull market it is difficult to not make money. In a bear market however only the best will survive. The industry benchmark index Credit Suisse Tremont was up in January for the first time in six months, figures released last week showed. Many prime brokers, hedge funds contacts at the big banks, and mangers argue they still performed well last year since they generated alpha, in other words did not fall as much as indices. In my opinion any manger defending their result by such an argument should close down. A hedge fund should always make money. The whole idea of the industry is to make money regardless of market conditions. I can agree that all managers will eventually have a bad year, however the extent of last year’s industry meltdown only testifies to one thing; there are not 9000 extremely intelligent fund managers in the world.

In the midst of the credit crunch investors are starting to realise this too. Redemptions have soared and are likely to continue. Many funds have to close. Fee structures have to be revised or investors will walk away. The very best will be able to continue to charge very high fees, but the average manager will have to change or get whipped out. Industry assets have shrunk to circa $1.1 trillion and will to continue to fall. This brings us to the questions what is the future of Hedge funds, what shape and form will they take? One thing is sure, as long as there are astronomical amounts of money to be made on the manager side just for managing money, they will always come up with a new idea of keeping it. I will discuss this topic in next week’s blog.