What is going on with hedge funds?

Damian Lewis makes hedge fund managers look good in the hit series Billions, but in real life hedge funds don’t do so well.

Hedge funds are making Damian Lewis look bad.

While the British actor makes hedge fund managers look like money-making mavericks in the hit series Billions, his real life equivalents don’t seem to do so well.

For eight years running, hedge fund managers have on average underperformed the S&P 500. Their infamous Two and Twenty business model has therefore come under pressure.

Hedge fund managers typically demand a 2% cut of all assets managed (the management fee) and 20% of the profits they make for the investor (the incentive fee).

That’s quite generous, as you might agree. It’s more than reasonable to expect above average performance in return.

That hasn’t been the case, especially of late. It’s caused Matthew Lynn to question the actual use of these funds in MoneyWeek:

“It is hard to work out any way in which they [hedge funds] benefited anyone other than their founders, and the few investors who managed to back the occasional successful one early on.”

But criticism doesn’t just come from the outside. Recently Glaswegian hedge fund manager Hugh Hendry declared the ‘pirate days’ of hedge funds to be over in an interview with Real Vision TV.

Of the hedge fund community Hendry said that “their right role is to be pirates, to be questioning, be challenging the consensus. Today, it’s more like the Royal Navy.”

Hedge funds have become part of the financial service establishment and their returns are no longer eye-catching.

What happened?

From attack to defence

Hedge funds started out managing capital for wealthy individuals and families and as such were a relatively small player in the financial world.

Where some praise them for providing liquidity in the markets and correcting inefficiencies through arbitraging, others denounce their hunt for short-term profits and creating asset bubbles.

German politician Franz Müntefering, for one, is not a fan. He once referred to hedge funds as ‘swarms of locusts’.

Still, for a while they were successful and repaid their investors’ trust with lucrative returns.

The golden age for hedge funds was the 1990s and the 2000s, up until the financial crisis. The returns they were able to deliver eclipsed the performance of other funds.

But those high returns didn’t go unnoticed. Before long institutions and pension funds decided to pour large sums in these funds, hoping to multiply their returns.

This created problems for a number of reasons.

Hedge funds saw their clientele change from wealthy individuals to institutions and funds.

It left them no longer able to do what they did best: getting high returns. The sums they had come to manage were now simply too big to invest in undervalued stocks while still making huge profits.

Another reason for hedge funds’ declining performance is the rise in competition.

What happens to most booming sectors is more and more people will try to get a slice of the cake. With many more companies looking for the same thing it’s become increasingly hard to find diamonds in the rough.

The change in clientele and exponential growth in funds that came with it have transformed their purpose.

Their focus has shifted from seeking high returns for a small group of individuals to retaining assets for large collectives of people in the form of funds.

With billions to manage all hedge fund managers need to do now is retain their clients’ assets to make gains. They’re no longer on the offensive. Defence is the new creed.

As it turns out Hendry’s pirates and Royal Navy metaphor works quite well.

An uncertain future

Like a successful indie rock band growing too commercial, going mainstream doesn’t always mean a change for the better.

Hedge funds seem to be experiencing this phenomenon at the moment.

Especially since the crisis the rise and rise of hedge funds seems to have come to an end. In March Fortune reported that “for the first time, more investors are cutting their hedge fund exposure than are increasing it” with big investors pulling out of the hedge fund game.

Claims that hedge funds are now firmly cemented in the financial world’s establishment may therefore be a bit premature. There are simply too many challenges ahead.

One of these challenges is to rethink their business model.

Now that hedge funds are losing their high yield status, they’ll have to adapt their fees to stay competitive. Maintaining their Two and Twenty scheme could see many clients taking their money elsewhere.

Another problem hedge funds face is increased legislation.

The success of hedge funds largely depends on them being able to operate more or less unconstrained in public markets. But in the aftermath of the global financial crisis regulators painted a big bullseye on their backs.

As Alexandros Seretakis wrote in the NYU Journal of Law and Business, “hedge fund regulation became a major pillar of the EU’s envisioned post-crisis regulatory regime.”

Hedge funds were thought to have contributed to the crisis while being largely beyond the grasp of regulators. Politicians sought to change that.

Seretakis therefore predicts:

“The cumulative impact of EU legislation will lead to the diminution of the hedge fund industry in Europe by squeezing its profits and curtailing the competitive advantage of hedge funds”

The UK has always dragged its feet in this area though, reluctant as it is to regulate the financial markets as much as its EU partners.

No surprise hedge funds were a minority group in the City that favoured Brexit!

Still, even in a potentially less regulated UK market hedge funds may have to reinvent themselves to stay in business.

In today’s world of low returns even the pirates of yore find it hard to locate treasure. Their business model will have to reflect that.

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