Although the hedge fund industry has been steadily recovering from when it hit rock bottom in 2008, it still is underperforming some key benchmarks. Nonetheless, institutional investors are still happy with the industry’s performance, as IBISWorld reports that returns on hedge funds have surpassed 84% of institutional investors’ expectations in the last five years.
Hedge fund performance continues to improve
According to IBIS, assets under management in U.S. hedge funds surged 18.2% in 2013. As a result, the firm estimates that revenue across the whole hedge fund industry in the U.S. will rise at a 7.9% annualized rate from 2010 through this year, which would mean revenue could go as high as $70.7 billion this year. That includes this year’s expected 7.5% increase in revenue. (All graphs in this article are courtesy IBISWorld.)
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U.S. hedge funds lag behind benchmarks
Hedge funds have drawn criticism lately, however, as they have underperformed traditional benchmarks over the last few years. Bloomberg data indicates that the S&P 500 Index beat the broader hedge fund industry’s return by 22 percentage points in 2013.
Also stocks from companies in the developed world outperformed hedge funds from 2013 through February 2015, rising by almost 40% during that time frame. By comparison, a major hedge fund performance index has increased less than 10% during the same time frame. The last time the hedge fund industry performed better than U.S. stocks was in 2008 when the financial crisis hit and hedge fund losses were not as bad as the S&P 500’s massive loss.
While some in the industry debate about whether key benchmarks like the S&P 500 Index should be used to measure hedge fund performance, there was a time when they did outperform such key benchmarks. IBISWorld reports that data from KPMG and the Imperial College London’s Center for Hedge Fund Research indicates that hedge fund returns did exceed the benchmarks between 1994 and 2011 “by a wide margin.”
In fact, the data indicates that the average hedge fund return was 9.1%, while the average equity return was 7.2%, the average bond return was 6.3% and the average commodities return was 7.3%.
What’s hurting hedge funds?
The biggest problem hedge funds are dealing with right now is the Swiss National Bank’s decision to eliminate the fixed rate on the Swiss franc against the euro. The result was a massive spike in the franc’s value and huge ripples of volatility through the currency market. As a result of that spike, Everest Capital had to shut down its main hedge fund, according to IBIS, because it had bet big on the Swiss franc’s decline—and lost.
The hedge fund’s performance is in direct contradiction with the soaring amount of assets under management and the positive sentiment of institutional investors.
Hedge fund compensation hit by underperformance
According to IBIS, one reason some give for the decline in hedge fund performance is the sheet size of the industry because the number of “very talented” fund managers may be limited. Other suggested reasons include the industry’s “highly leveraged” structure and the large amounts of fees.
But whatever the reason for the decline, as a result of the lagging performance, the traditional fee structure in the hedge fund industry has been affected. According to Hedge Fund Research data and The Economist, the traditional 2% fee on total assets under management and 20% of profits are now close to 1.4% on total assets under management and 17% of profits earned.
Meanwhile higher regulation and compliance costs continue to rise, taking bigger and bigger bites out of hedge fund profits. In spite of these factors, however, profitability in the hedge fund industry is on the rise. The average profit margin (EBIT) climbed from the 2010 recessionary low of 17.4% to about 24.4% as of this year.
Where will hedge funds go from here?
Because of the positive sentiment on the hedge fund industry, IBISWorld reports that the amount of assets under management is expected to rise consistently through 2020. Meanwhile demand and optimism for new hedge funds continue to rise, and the argument that hedge funds shouldn’t be measured against equities any longer is beginning to gain a foothold. The reason for this is because many hedge funds don’t rely on stocks.
For these reasons, it’s expected that revenue across the hedge fund industry will climb at a 4.6% annualized rate in the next five years, hitting $88.6 billion by 2020. However, mounting regulations and declining service fees are expected to more than offset the benefit of the rising amount of assets under management during the time frame, having a major impact on profitability.
As a result, IBIS speculates that the average profit margin in the hedge fund industry will slip from 24.4% this year to 22.9% in 2020.
Average hedge fund compensation: $347,000 a year
According to IBISWorld, this year employee compensation in the hedge fund industry is expected to make up 14.9% of the industry’s revenue, a slight increase from 2010’s 13.8%. In spite of the fact that compensation is such a small percentage of revenue, however, the average hedge fund employee is expected to rake in $347,216 this year alone.
Included in compensation are wages, bonuses and profit-sharing. In
the next five years, IBIS reports that wages as a percentage of revenue are expected to keep rising as hedge funds face off with each other for the industry’s most talented employees. Additionally, the report notes: