Hedge Funds Could Become Commoditized As Fee Pressure Bites

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At the end of June, I covered a research paper from Wulf A. Kaal, the Associate Professor at the University of St. Thomas School of Law (Minneapolis), which considered the impact of blockchain on the asset management industry. The research report considered the impact the technology would have on average Hedge Fund fees as it allows more transparency and security in the investment process.

The threat of blockchain on fees is the latest threat to hedge funds and their traditional structure. In recent years, hedge funds have come under attack from various angles as their high fees, poor returns and excessive spending draws criticism.

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The industry is already feeling the impact of investors’ ire. As previously reported, according to the latest Market Microstructure report from Hedge Fund Research, average hedge fund management and incentive fees declined by one basis point to 1.47% in the first quarter of 2017, and the average incentive fee fell ten basis points to 17.3% that’s across the total number of active hedge funds surveyed of 9,733. Of the 189 hedge fund launches during the first quarter, the average management fee increased to 1.4%, up slightly from the average fee of 1.3% for 2016 launches.

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However, despite all the talk of the death of hedge funds, the alternative asset class remains popular with investors. There are roughly 10,000 hedge funds worldwide, and there was a net decline of approximately 400 funds last year, 4% of the universe and the second-highest number of closures on record outside of 2008. Nonetheless, while the pace of closures is accelerating, hedge funds are not, as of yet, closing so fast as to threaten the entire asset class’s survival and the closure trend will have to accelerate dramatically to meet the most pessimistic forecasts.

As fee pressure bites, Average Hedge Fund hurts

K.C. Nelson, the lead portfolio manager at Driehaus Capital Management, has been one of the most vocal proponents of the so-called “hedge fund apocalypse” so far, and he expects the industry’s pain to only accelerate going forward. In a letter to clients at the end of May Nelson laid out his three predictions for the industry’s further demise.

  1. Fees will continue to fall

Nelson claims that he has had three separate institutional investors tell him “they’ve had investment managers in their offices this year pitching product that charges a ZERO management fee.” Evidence that the average hedge fund fee charged will continue to fall.

  1. Performance remains a problem and is not improving

Even though hedge fund performance has improved in recent months, the HFRX Global Hedge Index is still being trounced by the S&P 500 at a much lower cost. Of course, it should be argued that comparing hedge fund returns to the S&P 500 is irrelevant because these alternative investments are supposed to provide diversification, and hedged strategies tend to outperform during periods of market chaos. It is quite likely they will continue to do so, but in today’s increasingly short term focused world, who is prepared to wait?

Hedge Funds Could Become Commoditized As Fee Pressure Bites Average Hedge Fund

  1. The hedge fund industry “increasingly goes one of two ways”

Nelson notes that the hedge fund industry is increasingly moving towards two different styles. Those funds that rely on computing power to manage investments and those that invest in highly illiquid alternative assets. Both may end up going nowhere (for most funds anyway). Nelson goes on to explain in the letter that for “those funds going the non-traditional, private market route, when the next market downturn occurs, you can bet virtually all of these bets are going one way, and in a less liquid market, that can mean severe markdowns.” Meanwhile, the computer managed automated funds will end up commoditizing their investment process as all computers look for the same signals. Therefore, assets will flow to those firms with the most computing power causing attrition across the rest of the industry.

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