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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