Hedge Fund Industry Hit Hard, But Talk of Demise is Premature

While hedge fund returns have been taking a beating lately, the talk of the demise of hedge funds is probably a little overdone and premature. While there has been $72.5 billion in outflows, this represents less than 4 percent of the average mid-year industry volumes (see Wealth Bulletin article). Also, while the industry has seen a number of funds close up shop, the numbers have "only" decreased from 7,601 to 7,299.

As I discussed a number of weeks ago (see previous post), the fallout seems to be impacting smaller funds more than larger, more established funds. In fact, many of the larger funds - which are either more diversified or have a star manager - are seen as being able to take advantage of the shifting resources and capital.

Even with fewer funds failing than originally expected (yes, these are just preliminary numbers), funds that stay in business will still find that they cannot operate as usual. For starters, funds will need to better match redemption rules with strategy. Some funds are illiquid by design, based on the strategy being used.

While trying to lock up funds until returns are realized (as with private equity) is probably not feasible, funds will need to better ensure that redemption request rules take strategy into consideration. The use of leverage will also no doubt be reduced for many funds, which will also affect returns going forward.

Finally, the popular 2-20 fee structure will also come under assault. Not only does the existing compensation structure seem excessive given recent performance (and future lower returns in the wake of lower leverage), fee concessions will be necessary as an incentive for agreeing to longer lock-up periods. In the end, expectations on both sides may need to be scaled down a little.