Hedge Funds Are the Ultimate Survivors

Bloomberg View -- You may have read a bit of negative news recently about hedge funds: high fees,  subpar performance and concerns about legal issues. That might be the sort of unholy trinity that would put off some potential investors. Combine that with the rise of index investing, and you have a recipe for inevitable industry decline, right?

Not so fast.

Despite the gloomy backdrop, hedge-fund assets under management have hit a new record. According to Hedge Fund Research. The latest data shows that assets increased to $3.07 trillion in the first quarter, surpassing the previous record of $3.02 trillion in the prior quarter.

There are several interesting data points in the HFR report, including:

Launches are increasing: There were 189 hedge fund openings in the first quarter of 2017. That is the first increase since first-quarter 2016.

Closings still outpace openings: There were 259 liquidations during the first quarter, a modest decrease from the 275 in last year's fourth quarter.

Net fund numbers are falling: During the year ended in March, 1,025 funds closed versus 712 openings, for a net decrease of 313. The total number of operating hedge funds in the HFR database is 9,733.

Fee pressure continues: The average management fee fell 1 basis point to 1.47 percent in the first quarter, while the average incentive fee fell 10 basis points to 17.3 percent.

Two-and-20 is vanishing: Perhaps the most astonishing data point is that only 30 percent of hedge funds charge the traditional 2 percent management fee and an incentive fee equal to 20 percent of the profits. “Two and 20” certainly rolls off the tongue more easily than “1.47 and 17.3,” but the traditional fee structure is no longer charged by the majority of funds. However, I was unable to find a fee breakdown based on assets under management (i.e., the biggest funds control the bulk of the industry's assets so perhaps it's premature to bury two-and-20 just yet).

The above details reflect broader trends in the rest of investing world. However, I see interesting things when we look at the hedge-fund industry.

• Higher costs and underperformance seem to lead hedge funds to experience the dynamism and turmoil of the marketplace faster than the rest of financial industry.

• Although indexing to achieve market-matching returns is relatively cheap and readily available, there remains a demand for outperformance. We have been trained our whole lives to excel, and that makes it difficult to come to terms with the advantages of average returns and low costs.

• The insistence on achieving above-average returns is a key to the embrace of hedge funds, especially among public-pension funds. There is no reason why the legal structure of an investment fund should boost the returns of the assets it invests in. But investment consultants hired by pension funds managed to create the perception that hedge funds could deliver above-market returns with some regularity.

Why should you care about this final point? Because underfunded public pension funds -- that’s almost all of them -- can play a nice little game with their books: When pension funds invest in hedge funds with their fabricated expected market-beating returns, pension managers can get away with contributing even less today to their future obligations for pension beneficiaries. That makes state budgets look better than they really are. It’s a scam that taxpayers will come to regret when the bill comes due.

Famed hedge-fund short seller Jim Chanos once said that back in the early days of hedge funds, there were a few hundred of them and most created alpha, or market-beating returns. He notes that of the almost-10,000 funds out there, it's still the same bunch that drives the bulk of the alpha creation. It’s a data point worth watching.

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

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