Tuesday, December 6, 2016

Hedge Funds Get Big or Go Home?

Lisa Abramowicz of Bloomberg reports, Hedge Funds Get Big or Go Home:
Hedge funds have had a rough year.

They have delivered unimpressive returns. They're battling one another for a stagnant pool of investor money. They're steadily lowering fees. The pressure is bifurcating the $3 trillion industry, helping to make big hedge-fund firms even bigger while sending many smaller ones into extinction (click on image).


Firms with more than $10 billion of assets under management can more easily afford to reduce fees and customize strategies. And that’s exactly what they’re doing, according to a recently released Ernst & Young global hedge-fund report.

Bigger firms have lowered fees more than smaller ones, which makes them more appealing to clients such as pension funds and insurers. Consider Brevan Howard, for example, which earlier this year cut some management fees to zero for certain clients. The once-average 2 percent management fee has fallen to 1.35 percent this year, Ernst & Young data show.

There have already been a slew of studies, some conflicting, about whether big or small hedge funds tend to outperform. The matter hasn't been settled.

But it certainly seems as if a higher concentration of money in a smaller group of firms will raise the financial importance of the largest ones. And this could be problematic if the risk isn't properly monitored. This is especially true among hedge funds, which tend to use leverage and derivatives.

While regulators have pushed more derivatives through clearinghouses to reduce the potential systemic risk from firm failures, the financial system is hardly immune to hiccups. For example, a Dec. 1 study from the U.S. Treasury's Office of Financial Research found that large firms that are significant net sellers of credit-default swaps could pose a significant threat to the financial system.

Meanwhile, this shift toward larger hedge-fund firms will only accelerate as fees continue to decline. Survival becomes a scale game. If a hedge-fund firm has enough assets, it can cut costs by outsourcing human resources, legal and back-office services and pay more to attract talented programmers and traders. It'll also have an easier time negotiating with its prime brokers. (click on image)


If not, the firm will likely go out of business in short order. Many have already done so this year, with the fastest pace of hedge-fund liquidations relative to new formations since 2009, according to HFR data (click on image).


Investors want to pay less for bigger returns. The result will likely be a smaller clutch of dominant, behemoth asset managers and a revolving door of smaller upstarts. While this may help cut costs, it also puts the onus on regulators and institutional investors to closely oversee any concentrated risks that may develop.
This is another excellent article by Bloomberg's Lisa Abramowicz. No doubt, big hedge funds are getting bigger and I'm going to explain to you why this trend will continue and what are the implications for markets and the global financial system.

First, there is a lot of money out there from large global pension funds and sovereign wealth funds all looking for the same thing: non-correlated, scalable, high risk-adjusted returns (ie "alpha") in public and increasingly in illiquid private markets.

Why illiquid private markets? There are a lot of reasons but I think the biggest reason is big institutional investors are fed up with the volatility in public markets and looking for consistent long-term yield they can find in real estate and increasingly in infrastructure investments. These asset classes not only provide solid, consistent yield over the long run (in between stocks and bonds), they also offer scale, meaning pensions and other big investors can put a lot of money to work quite easily, and they fit better with the long-term liabilities of pensions (long dated liabilities that go out 75+ years).

Now, hedge funds aren't illiquid alternatives, they are liquid alternatives. Sure, they aren't as liquid as investing directly in futures, stocks and bonds but they are far more liquid than private equity, real estate or infrastructure investments where capital is tied up for years, sometimes decades. And when a crisis hits, liquidity risk matters a lot, especially for mature, chronically underfunded pensions with negative cash flows.

But even with hedge funds that are suppose to offer uncorrelated alpha (most offer leveraged beta or sub-beta returns), scale is a huge factor for big investors which is why the big hedge funds are getting bigger.

Of course, one can also argue big hedge funds have unlimited resources to hire the best and brightest programmers, to outsource HR, legal and back-office services and negotiate lower fees with existing clients. Big hedge funds are also able to hire a big compliance department which is very expensive but needed as well as a big investor relations team to help market their fund and gather more assets.

Smaller hedge funds are in survival mode, especially in the beginning when they are building their track record. They need to charge 2 & 20 or some sort of fixed fee because they have higher fixed costs as a proportion of assets under management than their larger rivals.

But I don't think that is the biggest impediment for pensions to invest in smaller hedge funds. The big issue is scale. It's much easier writing a big cheque to Bridgewater, Brevan Howard, Appaloosa, Citadel, Renaissance Technologies and a bunch of other large funds than taking career risk to invest in a bunch of smaller hedge funds that may or may not outperform their largest rivals in a brutal environment.

This trend toward bigger hedge funds, however, presents opportunities to other smaller investors (like big family offices or small to mid-sized corporate and public plans) to focus their attention on smaller hedge funds that are not on the radar of the big pensions and sovereign wealth funds.

It also presents opportunities to revive funds of hedge funds which were almost extinct following the 2008 crisis. Good funds of funds are are better at tracking and finding small hedge fund gems and they have no issue signing good, mutually beneficial terms with smaller hedge funds who need to be properly incubated during their first three years after they launch.

The trend toward bigger hedge funds also places a need for policymakers to think of how they can use public money to incubate smaller funds or how the financial industry can create platforms to support smaller funds.

For example, in Quebec we have the Emerging Managers’ Board (EMB), a non-profit organization whose mission is to promote and contribute to the growth of Canadian emerging managers. There is even a Quebec Emerging Managers Program for hedge funds that can be found here.

Why is it important to support an emerging manager ecosystem? Because giving more money to big hedge funds supports jobs at their shops but it isn't enough to promote the financial industry and it also exacerbates rising inequality as the big fund managers get a lot richer, managing the bulk of the industry's assets (this concentration of wealth is unprecedented and while it's in their best interests, it isn't necessarily in the best interests of society and the economy or always in the best interests of their clients).

Smaller hedge fund managers are hungrier and typically have better alignment of interests with their clients than large asset gatherers looking to collect a management fee on billions (focusing less and less on performance and more and more on asset gathering).

However, this doesn't always translate into better performance because like I stated above, the big funds have all the money in the world to hire the best and brightest and negotiate better terms with their prime brokers, many of which do not even deal with smaller hedge funds (forcing these funds to deal with third tier brokers which adds operational risk to their performance).

Lastly, another negative of this trend into bigger hedge funds is that it dilutes returns, promotes crowding of trades (like Valeant but plenty of other positions across stocks, bonds and derivatives), and increases systemic financial risks as big hedge funds lever up their book to squeeze yield out of big trades (read "When Genius Failed").

Come to think of it, maybe this trend toward bigger hedge funds presents golden opportunities for smaller, nimbler, hungrier and smarter hedge fund managers that can capitalize on the collective stupidity of the larger funds. Maybe, just maybe, that remains to be seen.

Below, an older Opalesque interview with Bryan Johnson who explains why 89% of all hedge funds never get over $100m. Johnson believes that the primary reason why most managers do not get over the hundred million hurdle is not because of poor performance but because of poor marketing.

I couldn't agree more and wish I embedded this clip in an earlier comment on whether emerging managers can emerge as he highlights very important points far too emerging managers ignore.

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