Middle Out Compression

Guilfoyle explains the principles of middle out compression on ‘Silicon Valley’

It’s a tough time to be a middle man in asset management these days. The most grave example of this is the hedge fund of funds business.

I’ve been told that one of the most well-known FoF operations in the industry is now informally having the preliminary conversations necessary to begin the process of shopping itself. Its founders recognize that the future of the biz probably does not involve layering a 1-and-10 platform fee onto a portfolio of funds charging 2-and-20. And this without even adding in a brokerage firm fee charged by the wealth managers at the big investment banks.

This layering of cost makes it nearly impossible for the end-investor to actually make money even in good times for hedge funds.

And these are not good times.

For the first time in history, pretty much, the hedge fund industry is shrinking (stalling?). It probably hit its capacity at $1 trillion of assets, but, as these things often do, it proceeded to get completely out of control. The industry’s assets zoomed to about triple what it could sustain – $3 trillion – and then it just stopped, sometime around Q4 2015. Redemptions, fund closings, firings by high-profile pensions and institutions – this is the new normal for hedge funds. The fund of funds business standing in the middle of the investors and the hedge funds themselves is now feeling the compression.

Bloomberg News:

Funds of hedge funds lost more than $100 billion in 12 months because of outflows and poor performance, according to a new report.

Clients pulled $50.3 billion over the four quarters through March, while managers posted $51.5 billion in investments losses, research firm eVestment said Friday after analyzing data from more than 2,500 funds. Assets in the sector shrank 11 percent to $841.6 billion, the lowest since June 2009.

Funds of funds were once the largest single investor in hedge funds, accounting for almost 50 percent of assets in 2008. Now they make up 28 percent, eVestment found.

Flows follow performance and performance at the underlying funds isn’t there. Nor is it there at the platform allocators. How could it be? A friend of mine in the FoF business, upon hearing about an anti-hedge fund protest, jokingly quipped “I’d like to join it.”

Additionally, FoF platforms, while helpful for large investors who don’t know how to allocate, are facing the same skepticism that all other asset management middlemen now face:

Can you deliver what you say you can (risk-adjusted alpha)?

Does your sophisticated knowledge of the industry actually result in better than average returns for end-investors (mathematically difficult)?

Can you actually identify consistently outperforming emerging managers on a reliable basis?

Are the high quality funds you have access to now too high quality (read: too large) to continue to outperform like they did at a smaller size? 

These are tough questions. The FoF industry has to find a way to answer them in a language that can be understood, because the presumption of sophistication and patience among institutions might be overstated.

Lastly, every corner of asset management is facing fee compression, including the hedge funds themselves. It stands to reason that there won’t be a big enough slice in the middle to sustain the size of the FoF complex in a world of growing transparency, increasing information symmetry (everyone can see the same data online), a boom in liquid alternative funds in ’40 Act wrappers and the overly competitive landscape fueled by tens of thousands of new MBA kids entering the fray every year.

Perhaps shrinkage and a purge at the lower end is exactly what the FoF system needs.