Will hedge funds still be around in 5 years time?

Date: Friday, February 6, 2009
Author: GLG Group.com

This analysis is solely the work of the author. It has not been edited or endorsed by GLG.

Implications: Hedge fund fees have fallen and are likely to fall further. This will affect the viability of hedge funds. Their still excessive costs together with their lack of transparency and liquidity, operational weaknesses and lack of regulation (currently) are likely to push many investors into UCITS funds. This article argues that UCITS funds are a more suitable investment for most hedge fund investors, and that hedge funds will return to their roots as funds for the ultra-wealthy.

Analysis: The article states that hedge fund fees have fallen. Not only have they fallen but they are likely to fall further. No longer can hedge funds charge the old 2/20 formula, unless they really have performed over the last year and made a positive return (and 90% have not).

The problem is that many hedge funds have grown fat on the old performance fees, and have even being relying on performance fees to pay their operational costs. Those operational costs are only likely to escalate with an almost certain increase in regulation and oversight just around the corner.

So hedge funds face a number of challenges. They have an opaque structure derived from their secretive nature. That might have been acceptable yesterday when this added a certain cachet, but today investors demand transparency. Their costs are too high with 1% as the standard in the wealth management industry. Their operations are archaic, with excessive lead times and valuation times, and relatively little use of third parties. They can be very illiquid. Many hedge funds have brought the shutters down and stopped redemptions, even though they would appear to be in relatively liquid underlying investments. They are currently very lightly regulated, however they are likely to find themselves in a regulatory straitjacket in the future.

Many (most?) hedge fund investors do not understand exactly what it is they have invested into. They do not understand the risks involved. For these investors, who are after a reasonable absolute return, there is a more suitable alternative in the form of UCITS funds. These have lower charges (typically 0.5-1.5% with no performance fee), are transparent, typically use third parties to provide the fund administration and NAV calculation, are traded daily, settle on T+4, have independent oversight by a depositary and already have a well-respected set of regulations.

Under UCITS III, funds can now invest much more widely in derivatives, and can replicate many of the strategies of hedge funds, in particular providing absolute returns.

So are hedge funds likely to disappear? Not entirely - there will always be a place for hedge funds as they were originally conceived - as private investment funds for the ultra-wealthy. Will they still be called hedge funds? Probably not - "hedge fund" implies risk reduction and that is hardly an accurate description!