Business Insider | A ‘hedge fund apocalypse’ is coming

By May 20, 2016June 7th, 2016In the News

It’s the end of the hedge fund world as we know it, or so it appears.

K.C. Nelson, the lead portfolio manager at Driehaus Capital Management, has lain out a grim assessment of the industry in a commentary to clients that perfectly sums up the many issues facing the industry.

From long-term structural trends to current market conditions, Nelson lays out an ugly picture for hedge funds that he thinks will end with a massive shrinking of the industry.

“So what’s the bottom line of these changing industry dynamics?” Nelson wrote.

“I believe there will be a culling of hedge funds like we’ve never seen before. I’d estimate the number of funds gets cut in half over the next couple of years.”

Thus, the title of Nelson’s commentary: “The Hedge Fund Apocalypse.”

It all comes down to performance

Nelson, whose fund manages $8.4 billion in assets, argues that hedge funds’ biggest problem is performance, or more accurately the lack thereof. Nelson said all of the issues “start and end here,” noting that hedge funds had “gotten trounced by plain vanilla investments” since 2008.

In fact, the HFRX global hedge fund composite is down 1.19% over the past five years, while the S&P 500 is up 11.02%, the Barclays US bond aggregate is up 3.60%, and a classic 60/40 mix of stocks and bonds is up 8.20%, according to Nelson.

This lackluster performance is an even bigger problem given investors’ increasing impatience.

“Further, this underperformance is magnified in today’s marketplace, where investors are irritated after a bad quarter … or month … or week,” Nelson wrote. “The idea of investing over a market cycle is increasingly a foreign one.”

With increased scrutiny on returns, the dismal run of the past few years could not come at a worse time, given the increasingly itchy trigger finger of investors.

In addition, many hedge funds are beginning to crowd into the same trades, as Steve Cohen of Point72 noted recently at the Milken conference, making it harder for hedge funds to evendifferentiate performance among themselves.

There are other places for investors to go

In past cycles, a few years of underperformance would no doubt be a problem for hedge funds, but there was some sense that investors had no other place to go for the kinds of strategies the funds were providing.

Now, Nelson said, there are plenty of other avenues for investors that offer not only the same types of strategies, but also better returns in today’s market along with lower costs.

“There are a number of commodity, currency and credit funds to now choose from in ETF and mutual fund vehicles,” Nelson said.

“Moreover, there are a number of daily liquidity funds that run the hedge strategies themselves. This gives investors the option to tactically move in and out of exposures that previously they often had to access through hedge funds.”

This is similar to commentary we have heard from other funds. Highland Capital chief investment officer Mark Okada has said liquid alternatives, similar to hedge funds but with the ability to move money in and out on a daily basis, will be as disruptive to the industry as Uber has been to taxis.

Nelson in fact mentioned that many institutional investors such as pension funds and insurance companies were already quickly reallocating away from hedge funds.

“After years of inaction, the tide is now changing fast on this front,” Nelson said. “Whether driven by their own decision making or their clients’, the institutional consultant community is under severe pressure to justify the presence of hedge funds in client portfolios.”

To be fair, Nelson’s firm provides liquid alternatives, putting him in competition with the hedge funds he is discussing, but he acknowledges that even liquid alts are getting hurt by the shift as many investors are moving to private equity or basic portfolios.

The issue for both hedge funds and Nelson’s firm is that with so many options it becomes easier for large investors to move money to the best-performing investment type.

It will get ugly

Thus, you get the “culling” of the funds. But even those that survive, Nelson predicted, will be hit where it most hurts: fees.

“There will be a new push for lower fees, similar to the one that took average fees from 2 & 20 to 1.5 & 15 several years ago,” he said in the commentary.

The move to investment vehicles with lower fees is a more secular trend and is certainly not limited to hedge funds. But the push for lower fees from the aforementioned alternatives will hit the income of funds that are already struggling to make gains in the market.

Add together the miserable performance, readily available alternatives, lower fees, and restless investors, and you’ve got a tough road for the hedge fund industry.

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