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Building a Sustainable Hedge Fund Model

I had some thoughts on this a couple years ago when I said the traditional hedge fund model was antiquated. I want to revisit the thread in light of a couple stories today.

First is here (WSJ paywall) — Goldman Sachs is pulling back on less-profitable clients and charging existing clients more for services.

And the second is here — an ex-Bridgewater analyst a few years younger than me is starting a management fee-only hedge fund. Having gone through the experience myself, in a post-2008 world it’s incredibly difficult to get your start in portfolio management, and the obvious way to make it easier is undercutting existing managers on fees (leaving aside the #signaling question of what charging less implies about your product).

So if you’re running a hedge fund, costs are going up, and fees are going down. Looking out 5 years, it’s not going out on too much of a limb to think that equity multiple expansion will be minimal, and interest rates could rise, making performance much more challenging than it’s been over the past 5 years.

What this says to me is the cost structure of the industry will have to go down significantly unless clients are willing to pay 3%+ of AUM a year in fees in exchange for low to mid single digit returns. I think more highly of clients than that to expect the latter to be the outcome.

Some thoughts on what could happen…

Major industry consolidation: We don’t need 8,000 firms with their own compliance, legal, finance/back office, client communications, IT, and trading/ops groups. Most of the time portfolio managers start hedge funds because they want control over the investment process and the business upside if the firm succeeds. They don’t want to deal with actually “running the business of a hedge fund.” With industry profit margins likely to fall, PM’s will have to choose between lower pay and giving up control in exchange for a lower cost structure.

Prospective hedge fund managers thinking of themselves like aspiring musicians do: Taylor Swift is the music industry’s equivalent of SAC in its heyday. She can charge whatever she wants. You, however, are not Taylor Swift. You probably need to put your music on YouTube, Spotify, iTunes, and hustle for gigs at dive bars to grow your business and raise assets. What does that mean for aspiring PM’s? If you’re not bringing the weight of an established firm and/or $100mm+ and a 3-year track record to the table, you’re going to have to do everything possible to make the sale with early clients — low fees, full transparency, and anything else that’s necessary. You may have to live out of your house or split office space. Once, or if, you’ve raised significant assets and built a track record, then you can start charging clients more, if you can find some willing to pay a higher price.

Vested incubators that offer true partnership and infrastructure in exchange for a piece of the firm: Compared to the tech/venture capital industry, the hedge fund industry is an embarrassment when it comes to an ecosystem that looks for emerging managers. Any yokel with an idea for an app can raise money on a platform like Kickstarter or AngelList. Nothing like this exists in investment management. 10 years from now the Buffetts and Grosses and Icahns of the world will be gone, and who will take their place? Right now, nobody’s being groomed and there’s no established training grounds for aspiring managers in their 20s and 30s. Many of the best and brightest have gone to work in tech or other industries. When the old guard retires there’s going to be a dire shortage of managers.

Even as Wealthfront-type models gain share, there is always going to be a place for active management. We’re still in the shakeout of active managers who made their names in the ’90s and ’00s, but eventually the industry will be grasping for a solution to these problems.

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