April 18, 2016

Hedge Fund industry facing tough times

Peak Hedge Funds" has become another of The Many Peaks I See. At the minimum, I think that hedge funds' market dominance is over, and that a diminished role for this asset class could prove destabilizing for stocks. And at most, I believe that hedge funds' maturing life cycles and falling influence could have major impacts on markets in 2016-17.

Stocks' recent "rally of laggards" represents just the latest threat to the hedge-fund industry, which has continued to underperform the broad market. Tough redemption rules will buffer the blow for now. But I believe this key category will face a continued contraction in existing funds' size, coupled with the steady death of many smaller funds (and even some larger ones). 

Here 10 reasons I see as to why hedge funds are in trouble:

1.    Poor Investment Performance. Concentrated hedge-fund bets in underperforming, wrong-footed investments like Allergan, Sun Edison, Valeant Pharmaceuticals and the energy sector have become commonplace -- and in many cases, spectacularly unsuccessful. Bill Ackman's Pershing Square Fund is a vivid and recent example.

2.    Big Bets Have Downsides. Brokerages and other financial institutions take an accounting "haircut" for concentrated portfolio positions, but hedge funds don't. Instead, they mark their asset prices to the last sale. This aggressive accounting method is an untold industry secret that can easily backfire if positions sour. While Carl Icahn has very little public money in his fund, just look at his concentrated portfolio. The lesson here: Selectivity can work both ways.

3.    Little Liquidity. Investors have begun to recognize that a lack of liquidity typically accompanies concentrated investment portfolios. The 2010 Dodd-Frank law has dismembered the brokerage industry's role as liquidity source.

4.  High Fees. Given the sector's disappointing performance over the past several years, hedge-fund fees are simply too high to justify institutional or high-net-worth inflows. Funds will likely lower fees going forward, but that could change the industry's texture and composition.

5.    Size (and Success) Matter. Many high-profile funds are beginning to recognize that their portfolio sizes -- and the artificiality of markets dominated by quant strategies and central-bank policies -- make delivering superior investment returns difficult. And many are led by very wealthy individuals who are starting wonder why they should even try. Some of these executives are losing the "fire in the belly," closing up shop or returning capital to investors and becoming family offices that simply manage their own investments.

6.    Larger Funds Don't Have Flexibility. The market has seen a violent rotation into cyclical and industrial stocks over the past six weeks, but few if any large hedge funds played this aggressively. They're simply too large or not flexible enough to do so.

7.    Funds Can't Handle a Sustained Downturn. Should stocks ever correct and stay low, large high-profile funds will be unable to participate. They're simply too big and inflexible. Some have even abandoned their short-selling strategies and personnel in the recognition that shorts can't provide an effective hedge for such big portfolios. Borrowing costs have risen and the number of "hard-to-borrow" shorts has increased.

8.    The 'Billions Effect' Weighs on the Industry. Like the players in Showtime's series Billions, some hedge funds might have walked on the edge of the law and could face investigations by authorities. This could further damage the industry's reputation and ability to attract inflows (if not worse).

9.    Political Considerations. The growing schism between America's "haves" and "have nots" has focused politicians' attention on billionaire hedge hoggers, many of whom have been a little too conspicuous in their consumption. Although many of these people are also extremely charitable, continued political focus could further jeopardize the industry's popularity among institutional investors.

10.    Carried-Interest Tax Issues. As an addendum to the point above, the generous tax treatment that hedge-fund executives currently enjoy on carried interest will likely continue to face serious targeting by politicians. This will make the industry less profitable to its principals and employees, again risking a changing risk-vs.-rewards texture to fund ownership.

The Bottom Line
I'm not predicting the hedge-fund industry's death, which has been forecast on numerous occasions in the past. I'm just predicting that tough times lie ahead.

But I'm unsure who wins if the industry's woes continue. Wall Street is a zero-sum game and money that exits hedge funds has to go somewhere (although risk aversion could change that). My guess is that the machines, algorithms and other quant-fund strategies could benefit, increasing their already-outsized market role and dominance -- and creating even more market volatility and potential disruptions.

Either way, the bottom line is that due to the threats above, I think the outlook for traditional, ol' fashioned stock-picking hedge funds seems problematic for at least the next year or two.

via thestreet