Funds Funk Expands to Long-only Managers

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 New York – News that Fidelity is considering laying off as much as 9% of its total workforce hit the wires today. A Wall Street Journal article indicates that as many as 4,000 employees may be affected by the move. A spokesman for the fund said that the layoffs would affect a number of business units, including the investment management arm of the business. Below we precise the Wall Street Journal Article and the impact on mutual funds as well as rehash information already revealed on the hedge fund industry. Finally we assess the likely impact on the research industry.

Long-Only funds

In earnings releases by other long- only funds, such as Janus Capital Group, AllianceBernstein Holdings and American Century Investments statements about potential staffing reductions were raised. In the current environment money has been flowing out of equity funds and into money market funds and fixed income funds. Within the fixed income funds, much of the money flow is moving into the safer treasury security based funds.

The fund business’ profitability is largely fed by the equity fund business, which tends to generate greater returns than do money market funds and fixed income funds. Data from Trim Tabs, a California-based firm that analyzes investment fund flows, indicates that net redemptions will reach $75 billion in December, following $43 billion in net redemptions in September.  

To date much of the news has been about the investment banks and hedge funds that have been trounced by the credit crunch. While we have predicted that it would affect long-only managers, this is the first round of hard news on the impact on mutual funds. In 2002, Fidelity laid off roughly 5% of its work force, making the current crisis roughly twice as serious for employees.

Hedge Funds Lose Assets, Many Close

One development that has plagued many hedge funds has been a precipitous drop in assets – either as a result of falling stock prices or as a result of investors pulling their money out of the funds.  Hedge Fund Research (HFR) reports that hedge fund assets declined by $210 bln, or 10% in the third quarter of 2008.  Redemptions in the third quarter were a record $31 bln, eliminating the inflows into hedge funds in the first half of the year, and leaving the industry with net outflows of $2.5 bln on a year-to-date basis.

Some research firms estimate that the hedge fund industry experienced even sharper redemptions in recent months.  Trim Tabs estimates that investors withdrew at least $43 bln from US hedge funds in September alone.

Unfortunately, these redemptions are not expected to slow anytime soon.  JP Morgan has estimated that hedge fund outflows could total up to $150 bln over the coming year, leading to asset sales worth about $400 bln.

These redemptions have already prompted many hedge funds to close up shop.  HFR estimates that in the first half of 2008 close to 350 funds have shuttered their operations.  However, that does not include the third quarter, where most of the redemptions took place.  Ken Heinz, the president of Hedge Fund Research, says he wouldn’t be surprised to see 1100 funds liquidate this year.

Longer term, the outlook for the hedge fund industry doesn’t get much brighter.  For example, analysts at Credit Suisse project that nearly 30% of the 8,000 hedge funds currently in existence will close in the next few years.  One chief executive of a top alternative investment manager said he expects the hedge fund industry will shrink by 50% in coming few years – with half the decline coming from withdrawals and half from investment losses.

Consequences for Research

So what do these trends mean for the research industry?  First, we suspect that many research providers – both sell-side firms and independent research providers – will suffer as the sheer number of current (or potential) clients drops.  In our view, the firms that will bear the brunt of the difficulties will be the smaller regional players and the indie shops that produce undifferentiated fundamental company research.

This trend will be exacerbated by the fact that the amount of commissions available to pay for third-party research should also plunge (see our blog on this topic at http://www.integrity-research.com/2008/10/06/bear-market-likely-to-leave-research-firms-wanting/ for details).

In contrast, external investment research should become even more important to any small and mid-sized hedge funds that survive the current massacre as these firms are likely to remain lean, thereby having fewer internal resources to do their own research.

Unfortunately, these smaller firms may find it more difficult to get the attention of many research providers (particularly the larger sell-side firms) as their smaller asset bases and more limited commission budgets won’t make them attractive clients.  These small and mid-sized hedge funds may find they are better served by independent research providers who have lower revenue expectations.

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