Hedge funds have been in the press repeatedly over the past two years. Some of the news has been good, but the large majority of it has been bad.
Warren Buffet has stated that hedge funds get huge fees for bad results. And both political candidates for president have talked about closing financial loopholes in the industry.
Does that mean that mega wealthy investors will have to find another place to grow their money? Anticipating the future is never easy, but a number of factors allow industry analysts like myself to make reasonable assumptions.
Current Status
In trying to predict the future of a market as large as hedge funds, the first step is to look at where things currently stand. As it is, hedge funds total roughly $3 trillion in assets, and they have seen overall profits for the past decade.
So far, 2016 is shaping up to be about 10 percent less profitable than 2015, but the major players are still anticipating tens of billions of dollars in profit by the end of the year.
The other major factor about the industry is the level of scrutiny being aimed it. Both major political candidates have suggested closing hedge fund tax loopholes, and the entire industry is under fire for a fee structure that just doesn’t seem to be working anymore.
Assets
This most important thing to note about hedge funds as a whole is the size. The $3 trillion in assets is too much to disappear quickly.
Even more noteworthy is that of that $3 trillion, 90 percent of the assets are managed by the top 10 percent of account managers. This means that accounts are huge, and they are likely to only get bigger. The “little guy” managers may struggle to stay in the game, so you can expect everything to continue to trend towards the mega funds.
You may have seen, and will likely continue to see, media stories about major accounts dropping out of hedge funds. This has happened with some pretty big pension accounts, and the totals in withdrawn assets this year are in the tens of billions.
Ultimately, 10 billion is a small fraction of 3 trillion. The major hedge funds aren’t even blinking, and they won’t really notice the losses.
Fees
This is a major factor in hedge funds right now. Historically, most funds have operated under a “2-20” model. Hedge funds charge a 2 percent flat fee and a 20 percent fee on all profits. This is pretty steep for long-term investments, especially when you consider just how many retirement plans have been tied to the funds in the last decade.
As profits drop, and they have been, the fees start to eat up a much more noticeable fraction of profits, and this was the main cited reason for the major withdrawals that have happened so far this year.
The long and short of it is that most of the major fees are going to be reduced. The major account managers will hold out as long as they can, but competition is inevitably forcing a response.
Reduced fees will first be the way smaller accounts stay competitive, but when the big players drop their fees considerably, profits will rebound, investors will return, and the hedge funds will continue to grow their impressive holdings.
Taxes
There’s no escaping it: new tax plans are going after the hedge fund industry. Every major candidate seems to be on board with closing the loopholes, and the increased taxes will further eat profits.
This is another reason why fees are likely to drop, but it’s important to keep in mind that any changes to tax law will take a few years to implement. That gives the major account managers plenty of time to adjust their strategies. So, while tax revisions are a negative, they’re another drop in the hat when looking at the big picture.
Competition
The biggest thing that has slowed down the success of hedge funds has been rising competition. Hedge funds are at their best in a bear market, and the surging S&P 500 has overtaken hedge fund profit margins this year.
When smaller investment accounts can expect better earnings without paying for a management service, you can expect them to do just that. More than anything else discussed so far, surging passive accounts are what threaten hedge funds, and this is the true factor that is going to cause service fees to be slashed.
Once done, the profit difference between the types of accounts will be much less, enabling them to compete without choking each other. And, if markets take a turn for the worse, hedge funds will be there to scoop up all of the extra opportunity.
Regards,
Ethan Warrick
Editor
Wealth Authority
