Future of Hedge Funds Pose Bad News for Research

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New York, NY – According to a recent report published by Putnam Lovell, the hedge fund industry is likely to experience both positive and negative developments over the coming five years.  We suspect that these trends could be bad news for the investment research industry as demand for their products and services might slip as a result.


Good News and Bad News

In Putnam Lovell’s report titled After the Belle Epoque: The Future of Fund Management, the firm estimates that almost 2,000 hedge funds are likely to shut their doors by 2012.  However, many in the hedge fund business should also be quite happy as Putnam projects that alternative investments will make up 51% of the fund management industry’s revenue during the same time frame.

Significant growth in alternative investments are expected to come from various products including long/short vehicles, all-capitalization funds, and concentrated portfolios.  In addition, investor interest in these products will come from pension funds looking for steady, market-neutral returns and more aggressive investors looking for outsized returns.

The report blames the overall reduction in the number of hedge funds on the over capacity in the number of Hedge Funds and funds of hedge funds.  This trend has created a scenario where too many funds are chasing fewer truly unique investment ideas — a development which has led to increased correlation between funds and increased correlation with the broader equity markets.  Consequently, the report suggests that an increasing number of hedge funds have become “closet beta providers” whose performance is not warranted by the exhorbitant fees they charge.

The Impact on Investment Research

So, how might these conflicting developments impact the investment research industry?  Over the past few years, most investment research providers have received much of their new business from the hedge fund community — particularly if the research firm produces non traditional services like expert networks, channel checks, market research, or search based software.

While we believe that the growth in the amount of assets managed by the alternative investment industry will help some in the financial services business (e.g. prime brokers), we are not sure that research providers will be aided to any great degree.

In fact, we suspect that sell-side and alternative (aka independent) research providers will be hurt by the overall reduction in the number of hedge funds in existence.  This is due to the fact that most research firms’ businesses are not greatly influenced by the amount of assets under management, but rather by the number of clients they serve.  Consequently, a reduction in the number of hedge funds could limit the revenue opportunity of many research firms.

The only way we see this changing is if research providers are paid based on the amount of assets under management of their clients (a change we doubt will ever take place on a large scale basis). 

Of course, some variants of this approach are more likely.  You would expect that firms that have more AUM would also have a larger number of investment managers or analysts.  As a result, getting paid based on the number of users would be helpful in the future.  In fact, some bulge bracket firms currently do well under the broker vote system due to the large number of users of their research.

We have also spoken to a few research providers who, in recent years, have moved to a discreet per user pricing model for their research.  And while clients have initially found this approach to be somewhat unusual, it is an approach that is used by many other suppliers to the buy-side, including market data vendors, software providers, database suppliers, etc.

Unfortunately, most research firms don’t charge more for their research based on the number of users (or the amount of asset under management at a client firm).  As a result, we expect that a sharp decline in the number of hedge funds, as projected by Putnam Lovell, is likely to have a negative impact on the revenue of many sell-side and alternative research providers.

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