New York, NY – In recent months, most hedge funds have been embroiled in one of the most difficult market environments in the industry’s history due to extraordinary volatility, higher borrowing costs, and enormous redemptions brought on by a widespread investor panic. In fact, many hedge funds have been forced to sell assets in order to meet redemption requests, resulting in even lower stock prices. However, these are just a few of the developments facing the hedge fund industry that are likely to have profound consequences on the broader financial services business, and more specifically on the investment research industry.
Hedge Fund Returns Plunge
The most obvious development that has hit the hedge fund industry is the terrible performance seen by most firms in the industry. According to Hedge Fund Research (HFR), overall hedge fund returns dropped 8.8% during the third quarter, with a loss of more than 10% on a year to date basis. This puts hedge funds on track to post their first annual loss since 2002, when the average hedge fund recorded a meager 1.4% drop.
Equity hedge funds, a subset of the overall market, have posted a 15% average decline so far this year. By comparison, macro funds, which seek to profit from broad economic trends by trading stocks, bonds, currencies and commodities, have achieved a 3.3% gain this year.
Experts are quick to point out that this data could understate the performance of many hedge funds as the spread of hedge fund performance is extremely wide. Consequently, very few hedge funds are actually down by 10%, as a large number are either up 40% or down 50%.
This performance is consistent with the overall stock market as the Dow Jones Industrial Average has fallen 33% since the end of 2007, while the S&P 500 has plunged 36% over the same time frame. Unfortunately, most investors find it difficult to accept such weak performance from hedge funds given the high fees they pay these managers.
Hedge Funds Lose Assets, Many Close
Another 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. 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, a California-based firm that analyzes investment fund flows, 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.
Hedge Fund Jobs Decline
The poor investment performance and massive redemptions seen at many hedge funds has led to a number of layoffs in the industry as management has seen this to be one way to bring their cost structures in line with plunging revenues.
The Options Group, a search firm that specializes in hedge fund placements, estimates that 3,000 to 5,000 hedge fund jobs have been eliminated so far this year, out of an estimated 150,000 jobs worldwide. Unfortunately, experts anticipate that hedge fund industry layoffs could double, hitting 10,000 by the end of 2008.
A few of well known hedge funds which have already started laying off staff include Perry Capital and Ramius LLC. Ramius recently laid off 40 of its 200 employees, while Perry Capital cut 20 positions, less than 20% of their total staff.
Executive search consultants note that the bulk of hedge fund layoffs so far have come from long/short equity hedge funds, whereas macro funds are doing some selective hiring.
Mutual Funds Regain Power
Whereas many in the marketplace might cringe in response to these developments, one group that won’t be is the mutual fund industry. Over the past decade hedge funds have grown in power as their asset base has grown, and as they have contributed to the profits of the largest investment banks.
However, a drop in both the assets under management and the number of hedge funds in existence will reduce their importance to the large investment banks and broker-dealers. In addition, some investors may decide to avoid hedge funds altogether given the high costs, the extreme volatility, and the subpar performance seen from many hedge funds.
Consequently traditional asset managers, including mutual funds and long-only investment managers, are likely to regain their preeminence in the investment world, both with their sell-side execution partners and potential investors.
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/cms/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.