Where is the Hedge Fund industry going?

As the former manager of hedge fund teams with the luxury of being able to view the industry from a different perspective, I am amazed that so many of the industry trends we discussed back in 2003/04 are still being discussed today. While it will invariably take 5-10 years for some of these trends to fully play out, we are already beginning to see some of our predictions coming true.

1. The number of hedge funds - higher or lower? Lower.

Back in 2003, when it seemed like 10 new hedge funds were being created every day, there were some who thought the growth would continue unabated due to forecasts of hedge fund AUM going up between 4-10x by 2010. Others, such as myself, felt that growth would shortly level off, and then potentially fall, as competition for these rising investment assets driven by the pensions and endowments (read: fiduciaries) called for a new kind of investment firm. This firm would have institutional scale and breadth, depth of management, best-of-breed policies, procedures, risk reporting and controls, and an array of strategies across which its managers could allocate opportunistically based upon market conditions. This firm would convey the benefits of fund-of-funds diversification without two layers of fees and have greater flexibility to optimize asset allocation. This firm would render obsolete the mid-size single strategy firms, as they had grown too big to generate the kind of alpha they had in their earlier, smaller days but were not sufficiently broad and nimble to take advantage of investment opportunities outside their vertical area of specialization.

This industry vision presaged the rise of the multi-strategy hedge fund complex, which was certainly not new but represented a tectonic shift in the way hedge funds were established, built, funded and marketed. Tanya Styblo Beder of Tribeca recently made a similar point in her CNNMoney discussion about the difficulty of being a single strategy fund in today's market. Tanya believes that the number of hedge funds could drop "by several thousand" over the next few years, and it kind of sounds like she is sounding the death knell of single strategy stand-alone funds.  I happen to believe that there will always be a robust business to be done in single strategy funds as many multi-strategy complex managers want to run their own show, sophisticated investors (with the requisite due diligence infrastructure) will want to do the asset allocation themselves across an array of single strategy managers and will want to reach for alpha generation, which is widely accepted to be in the first 2-3 years of a hedge fund's life. All of this points to an industry which will grow smaller by number of constituents but be made up of the super-big and the super-small, each geared towards a specific pocket of investors.

2. The "shape of the hedge fund industry?" A barbell.

As noted above, it seems that the "middle class" is getting squeezed and will have to make a decision - to "go global" or "go local." To be truly multi-strategy and have access to the best investment ideas across the spectrum,  a firm really needs representation in New York, London and Hong Kong, at a minimum. This is not cheap. A close friend of mine, who happens to be a very successful  long/short hedge fund manager running about $1.2 billion, recently told me that he feels at a competitive disadvantage to some of his peers who are running $3 billion and more. Why? Because they have the resources to set up offices in these locales (without presumably placing pressure on team compensation in the process) and gaining better access to information and ideas in these regions, and he feels somewhat strapped, especially in a tough market like this one. I couldn't believe I was hearing this from a friend running over a billion dollars, but times really have changed. So, if a guy running a billion is feeling pinched, how large do you need to be? $3 billion? $5 billion?

It seems that the high end will be defined by those with the resources to support and sustain a global multi-strategy platform, with a world-class infrastructure to support the operation. So what about going local, staying pure to your initial style and demonstrating superior alpha generation across a manageable asset base? I think this is a viable and rewarding strategy for someone who either runs their firm as a lifestyle business, or is setting the stage to build a track record sufficiently attractive to garner the assets necessary to make the jump from local to global. This will serve to create a dynamic where you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

3. Will fund-of-funds continue to be relevant? Yes, but less so over time.

The fund-of-funds business grew up as a valuable tool for helping investors diversify their exposure to the hedge fund asset class while sharply reducing the need for in-house due diligence resources. This enabled institutions and HNW individuals to view the investment in a fund-of-funds as an asset allocation decision, i.e, I am willing to have 10% of my portfolio invested in hedge funds, as opposed to 20-40 individual manager selection decisions. Fund-of-funds professionals provide the due diligence expertise, the reporting and the risk management skills to manage these pools of investments on behalf of their clients. These services, however, come at the price of a second layer of fees, historically up to 1% of assets and 10% of performance on top of the individual managers' own fees. These fees have come under sharp pressure over the past 3 years, as institutional investors have gotten increasingly sophisticated at performing their own due diligence and risk management for single strategy manager portfolios while the proliferation of high quality multi-strategy funds have provided the benefits of diversification and asset allocation without the second layer of fees.

While I believe there will always be a group of institutions that will simply want the added protection of having a professional fund-of-funds manager when they report back to their boards, this group will, without question, shrink over time and place ever greater downward pressure on fees for providing these services.

This is only a sampling of the issues the hedge fund industry will be dealing with over the ensuing years, but hopefully this will provide you with some sense of historical context and a view of what is likely to happen in this rapidly evolving industry.

Comments

[Cliff Tan]

Roger:

Have your views changed since your original post?

[Brian Gillet]

Mr Ehrenburg,
I was reviewing some of your posts regarding the hedge fund industry and the evolving investment research industry last night.
This morning I saw on FT (http://www.ft.com/cms/s/48a6887c-2e7d-11dc-821c-0000779fd2ac.html) that 1H07 hedge fund performance and fund count are being released. Will you be updating your view on the hedge fund industry soon?
The article does appear to be a bit one-sided since it does not indicate how many funds closed their doors in 1H07. I did some searching and could not find any data on closings for 1H07 and I could not find any data points related tot he shape of the hedge fund industry, but will forward on any stories I see in the near future.
I am very curious to see where the industry is headed since my company services it. I have worked at an independent research firm for over six years and am trying to look ahead at where opportunities will be. Keep up the good work here on Information Arbitrage!

[Yaser Anwar]

"Others, such as myself, felt that growth would shortly level off, and then potentially fall, as competition for these rising investment assets driven by the pensions and endowments (read: fiduciaries) called for a new kind of investment firm."

It's happening now. 2006 has been the banner year for HF underperformance & catastrophies. Amaranth, MotherRock, Archeus, Pirate the most notable ones. Your prediction of growth leveling of should be right, but it could be at a much faster pace if we see another 2006 like year(s). HF business is like the 80-20 model, where 20% of the HFs control 80% of the assets. Having a hedge fund these days is like having internet back in 2000, almost every Tom, Dick & Harry have one. But are they successful? Nop.

"I happen to believe that there will always be a robust business to be done in single strategy funds"

If you look at some of the recent blowups, a lot of them have been acting more like single strategy funds than multi-strategy. One of the purposes of multi-strategy is that it allows you to reduce non-systematic risk, but if you look at Amaranth & Archeus Capital- both bet big on energy and went down, even though they were not supposed to double down on a single strategy.

"A close friend of mine, who happens to be a very successful long/short hedge fund manager running about $1.2 billion, recently told me that he feels at a competitive disadvantage to some of his peers who are running $3 billion and more. Why? Because they have the resources to set up offices in these locales (without presumably placing pressure on team compensation in the process) and gaining better access to information and ideas in these regions.."

Competitive disadvantage because he's not located there? Hmm. Mr. Ehrenberg I don't know if you've read Steve Drobny's Inside The House of Money- In that Steve highlights to very successful macro HF managers- Jim Leitner (Falcon Management) & Peter Thiel (Clarium Capital) both which invest in countries around the world, yet have no offices outside of the US. Jim & Peter both talk about how they don't need a presense in countries they invest in thanks to technology which makes it relatively easy for HF managers to have all the data they need on their PCs. (Oh, if you haven't read the book, I would highly recommend it)

IMO- it was important to come back to this post. In the words of Arnold aka Terminator, "I'll be back." (by year end or mid 07, hopefully.)