Hedge Funds Get Big or Go Home

Survival of the largest brings with it potential threats to the system.

Hedge funds have had a rough year.

They have delivered unimpressive returns. They're battling one another for a stagnant pool of investor money. They're steadily lowering fees. The pressure is bifurcating the $3 trillion industry, helping to make big hedge-fund firms even bigger while sending many smaller ones into extinction. 

Uneven Flows

The biggest hedge funds have attracted a disproportionate amount of 2016's flows

Source: Ernst & Young

Firms with more than $10 billion of assets under management can more easily afford to reduce fees and customize strategies. And that’s exactly what they’re doing, according to a recently released Ernst & Young global hedge-fund report.

Bigger firms have lowered fees more than smaller ones, which makes them more appealing to clients such as pension funds and insurers. Consider Brevan Howard, for example, which earlier this year cut some management fees to zero for certain clients. The once-average 2 percent management fee has fallen to 1.35 percent this year, Ernst & Young data show.

Discount Aisle

Hedge-fund fees have gone down in recent years after generally underwhelming performance

Source: Ernst & Young

There have already been a slew of studies, some conflicting, about whether big or small hedge funds tend to outperform. The matter hasn't been settled.

But it certainly seems as if a higher concentration of money in a smaller group of firms will raise the financial importance of the largest ones. And this could be problematic if the risk isn't properly monitored. This is especially true among hedge funds, which tend to use leverage and derivatives.

While regulators have pushed more derivatives through clearinghouses to reduce the potential systemic risk from firm failures, the financial system is hardly immune to hiccups. For example, a Dec. 1 study from the U.S. Treasury's Office of Financial Research found that large firms that are significant net sellers of credit-default swaps could pose a significant threat to the financial system.

Meanwhile, this shift toward larger hedge-fund firms will only accelerate as fees continue to decline. Survival becomes a scale game. If a hedge-fund firm has enough assets, it can cut costs by outsourcing human resources, legal and back-office services and pay more to attract talented programmers and traders. It'll also have an easier time negotiating with its prime brokers. 

Big Getting Bigger

The largest hedge funds have been more successful than smaller ones at raising money

Source: Ernst & Young's 2016 Global Hedge Fund and Investor Survey

If not, the firm will likely go out of business in short order. Many have already done so this year, with the fastest pace of hedge-fund liquidations relative to new formations since 2009, according to HFR data. 

Closing Shop

This year's hedge-fund liquidations have outpaced new launches by the most since 2009

Source: HFR

Investors want to pay less for bigger returns. The result will likely be a smaller clutch of dominant, behemoth asset managers and a revolving door of smaller upstarts. While this may help cut costs, it also puts the onus on regulators and institutional investors to closely oversee any concentrated risks that may develop. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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