Hedge funds, in the aggregate, turned in an abysmal performance in 2015. Moreover, this appalling performance hangs like an albatross around the necks of funds both small and large, making the prospect of growing assets under management (AUM) that much more challenging in 2016. For hedge funds, AUM is not an end unto itself, as many would have you believe, but rather, a key element for a successful fund.
Separating Fact from Fiction
Much has been written about the small, nimble hedge fund and the advantages they enjoy over larger, clumsy firms. While this may have had a degree of merit in the past, the evolving dynamics of the industry have made this view somewhat arcane.
The principal driver of escalating operating costs in the modern hedge fund can be traced to increased regulatory burdens. At the same time, the traditional “two and twenty” fee model has suffered considerable erosion in the wake of consecutive years of industry underperformance, significantly reducing fee revenue. As a result, assets under management must necessarily rise to achieve break-even. Some experts have cited $500 million as the minimum base required to support the expenses incurred by a hedge fund.
Meeting regulatory requirements in today’s hedge fund requires substantial increases in expenditures on technology. Investors also drive technology costs upward with greater demands for transparency and timely reporting, which can only be achieved, in a cost effective way, through technology. Additionally, greater use of technology exacerbates cyber security concerns and effectively addressing those concerns comes at a price. Lastly, the investment in technology is not an option if a hedge fund is to remain competitive.
Small Hedge Funds May Be on the Road to Extinction
Given the fiscal realities, it is difficult to envision a world in which small hedge funds can survive, much less thrive. However, technology can also provide a mechanism for reducing costs and enhancing efficiencies. One example of this is employing technology to integrate front to back office reporting.
Another option, already commonplace in the industry, is to outsource back office operations altogether. Outsourcing can often put skills sets and technology at the disposal of a firm that would otherwise be out of reach from a budget perspective. The point is this; small hedge fund managers must have a laser-like focus on controlling the costs of operating the business if they are to survive the headwinds of change confronting the industry.
The irony in all this is that small hedge funds need to become larger hedge funds in terms of AUM at a moment in time when the tools needed to accomplish this growth are on the wrong side of the small fund’s fiscal boundary. Unless small fund managers can develop a means to acquire the tools they need to compete for funds and grow AUM, it is very possible that we will be witness to the extinction of a large number of small hedge fund firms. The current volatility in world markets will only serve to hasten their demise. Many small funds find themselves at this crossroads today.