A persistent bull market, in part, has resulted in hedge fund performance falling short of the broader market. Colloquial wisdom suggests that investors have the potential to earn superior returns and enjoy lower fees by investing in mutual funds. In short, many outside observers believe investors are not getting what they paid for—it’s like going to Chez Paul’s for dinner and being served a Big Mac and fries.

Hedge fund managers counter that their primary responsibility is to preserve client capital and such comparisons to broader stock indices are inappropriate, if not outright unfair. They warn that when the markets turn bearish, they will be vindicated.

Hedge fund managers face problems with this argument because hedge fund underperformance is not limited to stock indices. Hedge funds are also underperforming low-cost, balanced mutual funds. These mutual funds are composed of stock and conservative investments such as bonds, which is not dissimilar to strategies employed by a number of hedge funds.

Regardless of these troublesome facts, hedge funds continue to grow assets under management at a rapid pace, more than doubling since the financial meltdown six years ago.

Why Will Hedge Fund Assets Under Management Continue to Grow?

The answer to the question of why hedge funds continue to attract the lion’s share of the alternative investment dollar is the combined impact of three factors:

1.) Fully 65% of the $1.76 trillion invested in North American hedge funds is invested by institutional investors, largely corporate and public pension funds, insurance companies, endowments and foundations. Investors of this stripe are understandably risk-averse. This statistically significant group of investors is willing to accept modest growth in exchange for capital preservation. As a result, hedge funds have become increasingly conservative, a natural response constructed to meet client expectations, which has had the equally predictable result of increasing assets under management.

2.) Imagine yourself as a well-paid public pension fund’s investment officer suggesting something as mundane as an investment in mutual funds. Really? Why should an individual pull down a six-figure salary for an investment strategy practiced by the masses? Once again, the mystique of a hedge fund investment plays a critical role. The assumption being that hedge fund investment requires a level of skill and expertise which justifies such compensation.

3.) Fears of market volatility increase in direct proportion to the length of time a bull market persists. Volatility concerns propel investors into the waiting arms of hedge funds and its promise of capital preservation. The longer the bull runs, the more intense becomes the sentiment for hedge fund investment.

What Will the Future Bring?

Although hedge fund returns have been disappointing, there is nothing on the horizon to diminish the excellent prospects for hedge fund growth in 2015. On the contrary—the industry is reaping the benefits of a “perfect storm”.  An already risk-averse client base, with no plausible alternative investment, driven by the increasing probability of a downturn will, once more into the breach, with its hedge fund partners leading the charge.

 

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With 2014 in the rear view mirror, the numbers defining hedge fund performance are beginning to coalesce. Enter Citigroup’s Third Annual Hedge Fund Industry Operating Metrics Survey.

Profits Plummet

Citing poor performance, Citigroup’s report suggests that hedge fund profits dipped to just under $22 billion in 2014, compared to $31.2 billion in 2013. This represents a decline in profitability of thirty percent. Given the consistent growth of hedge fund assets under management (AUM), this is a counter-intuitive result—increased AUM should translate to increased management fees.

However, Citigroup’s report suggests that the revenue shortfall stems from the broad shift in the hedge fund investor base to institutional investors; investors less inclined to pay hefty management and performance fees. In yet another year of uninspiring performance, management fees represent a disproportionate share of total profits, reportedly two and one-half times the revenue generated by performance fees.

Small Hedge Funds Suffered the Most

Small hedge funds (AUM up to $350 million) are the least likely to command out-sized management fees. Smaller hedge funds are therefore heavily dependent on performance fees to bridge the gap created by reduced management fee income to meet operating expenses. As a result, poor performance makes covering operating expense shortfalls a real challenge … one that has the potential to engender a cascade of small hedge fund closures in 2015.

Meeting the Challenge

Hedge fund firms must find a way to overcome the investor apathy that stems from 5 back-to-back years of meager returns. Clearly, retail investors, with an estimated $2.7 trillion sitting on the sidelines, are an attractive target. Many large hedge fund managers are exploring liquid alternative funds, that is to say, ‘hedged’ mutual funds, as a means to attract their share of the $900 billion projected to be invested in this new breed of financial product by the end of 2015.

Hedged mutual funds are an attractive option for large hedge funds which possess the scale necessary to manage mutual funds. Alternative mutual fund products grew at a dizzying forty-three percent clip in 2014. To put that into perspective, every new dollar that was invested in hedge funds was matched by 66 cents invested in alternative mutual funds.

This strategy is not without its drawbacks. Hedge fund managers have to consider the impact of offering low fee alternatives of their higher fee financial products. A cogent argument will have to be put forward to restrain existing investors from transitioning to lower fee alternative mutual funds.

Possibly the greatest challenge is one of compliance with an entirely new set of regulations, restrictions and reporting for mutual funds … not insurmountable, but very real.

As for Small Hedge Funds

To state the obvious, the key to the small fund’s continued survival is improved performance. They too enjoy certain advantages over their larger counterparts that may be exploited. While the Citigroup report paints a dismal future for many small hedge funds, only time can reveal the outcome.

Hedge funds, large and small, occupy a unique niche in the investment universe and are unlikely to “go gentle into that good night”.

(the full Hedge Fund Industry Operating Metrics Survey report can be viewed here).

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