Where is the Hedge Fund Industry Going, 2 Years Later?

In one of my first posts I made some projections concerning the future of the hedge fund industry:

1. The number of hedge funds, higher or lower? - Answer: LOWER
2. The "shape of the hedge fund industry?" - Answer: BARBELL
3. Will fund-of-funds continue to be relevant? - Answer: YES, BUT LESS SO OVER TIME

A recent commenter asked the following: Roger, have your view changed since your original post? I think it is high time I revisited my earlier predictions to see if anything has, in fact, changed my views.

Number of hedge funds

My bottom line on this issue back in July 2006 was:

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.

To be honest, I don't see things any differently. The big have clearly gotten bigger, whether you are talking about Fortress, Och-Ziff, Lone Pine or Citadel. Large, sophisticated investors have placed increasing value on the institutionalization of the largest players, offering stability of management, infrastructure, reporting, risk management and a control environment worthy of larger investment dollars. Part of this trend has slowed the small fund launches, notwithstanding the rise of the seeder programs. There has also been a continued trend towards multi-strategy funds, giving the managers the ability to allocate capital to those strategies best suited to current market conditions. Also, there has been a shake-out over the past two years, driving the marginal players out as the smart money has either gravitated towards the large, established players or the high-profile new fund launches by successful portfolio managers. I think it is increasingly hard to sustain a single-strategy effort in the face of competitive pressures from the multi-strategy behemoths. So net net, I still see the number of hedge funds as being on a slight downtrend before it plateaus. And I believe the market is getting more efficient at picking the great from the good, creating a healthy, purging cycle that will also force consolidation across the hedge fund universe.

Shape of the hedge fund industry

My view two years ago:

...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.

I am more confident in my view today than I was in July 2006. The "great squeeze" of the middle that was happening  two years ago is alive and well today. The big have gotten bigger. The middle have either made the jump to the big leagues or are in an increasingly tenuous position. And the small is an amalgam of new starts, falling stars and a small group of single-strategy managers with laser focus who are happy with their business. And as the costs of entry I'd argue have gone up, not down, this serves to reinforce the barbell shape of the industry. Why have costs gone up? Even in the face of rapidly declining technology costs, the infrastructure necessary to run institutional money has gone up, up, up, in terms of people, systems and the time it takes to administer such an organization. Further, as the largest firms move into every market and asset class, it has created an arms race that makes it increasingly difficult for smaller funds to compete. I believe this is an inexorable trend that shows no signs of abating.

The relevance of fund-of-funds

Roger, circa mid-2006:

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 an interesting one. I'd say that I got the theme right but the timing wrong. Why? Four words: Amaranth. Sowood. Bear Stearns. If there is anything that can shake the confidence of an institutional investor it is a colossal blow-up, and these are just three of the many we have witnessed since my original post. And the big beneficiary of this waning confidence in one's due diligence ability? Fund-of-funds. These institutional investors still need to generate returns, and they're not running away from the asset class. But many would rather pay away some fees and get the imprimatur of a top fund-of-funds than go it alone and risk personal and professional ruin. I'm not saying this is rational, but it is what it is. Plenty of fund-of-funds got smoked in these three high-profile explosions, but the mere perception of greater stability and security offered by fund-of-funds is enough to make the marginally-confident institutional investor sign up. But as a trend, I believe that alternative asset allocations will continue to rise, and that many will reach a cross-over point between hiring a fund-of-funds and building an in-house due diligence and risk management team. Eventually, both economics and control will dictate the construction of these in-house efforts, leaving fund-of-funds to a more marginal role in the investment landscape. That said, in light of the jittery markets and high-profile instances of hedge fund failures, this trend will take longer to play out than I had originally anticipated.

I guess two out of three ain't bad.

Comments

[miami]

Roger,

There are clearly more HF now than 2 years ago. Saying that the larger ones have gotten [mostly] bigger, altho plenty have gotten smaller - Amaranth, GSAM, Bear, et al, doesn't refute the fact that your initial answer was offbase.

Why do you think there are fewer now than previously? As you noted elsewhere, technology costs continue to drop. All you need is 1 investor, IT is cheaper, and plenty of law/acct'g firms will take you on for next-to-nothing at the start, or for a piece of the action.

[Patrick]

Roger, interesting post. Would you be interested in syndicating your content on the home page of my site? It's an online community of finance professionals ( http://www.wallstreetoasis.com ). I could add an RSS feed that will allow me to promote your blog posts to my home page (when i think it will lead to a good discussion and/or is appropriate), but I wanted to make sure you were comfortable syndicating first. The syndicated post would have a link back to your original post. Thanks, Patrick (you can reach me at wallstreetoasis@wallstreetoasis.com if you have any questions).

Also, if you are willing to provide a link to wallstreetoasis.com that would be much appreciated.

[WorldBeta]

I still don't understand why there are not any listed hedge funds in the US like there are in London, Switzerland, and Canada. There are about 50 funds with $20 billion AUM.

The US is over 10 years behind here.

[dug]

I really don't see how super large funds can stay an attractive investment vehicle. They can only outperform by increasing leverage or by investing in backwaters. The choice of death by leverage or death by illiquidity isn't very appealing to me.

CXO had a piece recently that showed the edge is typically gone within a couple years. I think size is a large part of that problem because it both reduces potential investments and makes the fund's actions in the market more obvious to others (plus more employees means more info leakage).

[Kris Tuttle]

I'm just getting into this hedge fund business but these predictions make a great deal of sense based on what I've learned so far. I'm amazed at the number of managers that don't have anything unusual they are bringing to the table. Being smart and hard-working is fine but where does the edge come from? I doesn't make sense to me that there are thousands of individual managers who are just trying to out work their peers and the market. There are only so many ways to have a sustainable advantage to generate strong returns. There are some historically great managers that made what appear to be really dumb mistakes in the last year or two based on their "experience."

[Chris]

Roger,
Let's say 5 years out, do large hedge funds start diversifying away their returns, especially as they become more mainstream and offer more strategies? Do you see the increase of assets into the industry as potentially harmful for the bigger players?

I guess what I'm envisioning is some kind of event or movement that will disrupt larger hedge funds which, for one reason or another, have lost their agility.

[iamverytall]

I'm in agreement on #2, and disagree with #1 and am somewhat on the fence for #3, at least for the short term. Here's why:

#1. If you look at the trend numbers for # of hedge funds over the last few years, they've been increasing at a very fast clip. According to the HFR, there are now well over 9,000 operating hedge funds, well over the 6,000 just at the end of 2003. There's way too much money in this space for people to not want to join the party, and there's plenty of talent within existing hedge funds that's just waiting for the opportunity to jump out and get their own personal piece of the pie.

Add on to that increasing flows from institutional investors and the continuing proliferation of investment strategies and you've got a recipe for more hedge funds.

I admit that in the long run, there will inevitably be shakeouts as the wheat is separated from the chaff. However, the market is hungry for the strong returns that it's become accustomed to and as long as that hunger is there, the supply of funds will keep growing.

#2. Yeah, that sounds right on.

#3. I think there's probably going to be an interesting convergence between the investment consulting and fund of funds business sometime in the future. I think the current level of interest in hedge funds is going to drive institutional investors to gradually increase their asset allocations to alternatives, and as that happens, fund of funds will not only be their chief method of getting acclimated, it will also be their CYA against potential damages should something blow up.

Moreover, a lot of these funds will be relatively small, and as long as hedge funds remain relatively opaque and difficult to access or compare, there will be demand for people who can provide that kind of service at scale. In addition, the fact that FoFs can give some of the smaller players access to funds that are otherwise closed will continue to be a big driver.

In the long run, once everyone becomes familiar with hedge fund strategies, the need for FoFs will likely diminish. But it strikes me that understanding the performance drivers in the HF space is significantly more difficult than understanding the drivers of traditional asset management and there will likely always be demand for someone that can deal with that. Still thinking about it, but those are my current two cents.