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Why Do Hedge Funds Fail?

Operational issues are the number one reason why hedge funds fail.

At the end of March 2018, assets managed under hedge funds hit an all-time high, but as 2018 stretched on, the losses began to mount.

  • The industry lost $88 billion in assets last year, the steepest decline since the financial crisis, according to eVestment.
  • More funds shut down (580) than opened (552) as of Dec. 3 2018, per Eurekahedge.
    • More than 3,000 funds have shut down since the beginning of 2015 (HFR).

In spite of losses, total assets managed under hedge funds is at $3.2 trillion, and 42% of fund managers were able to raise net capital in 2018, eVestment said

Starting a hedge fund can still be amazingly lucrative, but you must prepare for headwinds, as the way you handle these challenges will determine how long you survive, and thrive.

Why Do Hedge Funds Fail? 4 Reasons

Poor operations management

According to a Capco study, 50% of hedge funds shut down because of operational failures.

Investment issues are the second leading reason for hedge fund closures at 38%.

When break down everything that can go wrong, operations makes its case for number one.

Think about everything involved in day-to-day affairs:

  • Costs (labor, software, technology, insurance, benefits, taxes, legal, regulatory)
  • Legal and compliance matters (audits, reporting, taxation)
  • Employee staffing (human resources, recruiting, hiring, and training)
  • Monitoring efficiency in the middle- and back-office

Now think of everything that can go wrong:

  • Rising operational costs
    • Failure to monitor and manage costs
  • Lack of transparency
    • Failure to comply with legal and regulatory agencies
  • Poor hiring and training practices
  • Being understaffed or overstaffed
  • Unethical and dishonest employees
    • Embezzlement, fraud, misrepresentation of assets, unauthorized trades, conflicts of interest
  • Inefficient use of technology and labor

Some of the biggest hedge fund failures are operations-related.

Bernie Madoff might be the most egregious offender through his multi-billion dollar Ponzi scheme. Proper audits and oversight would have caught criminal behavior like this earlier.

The Bayou Group defrauded investors worth more than $400 million through false accounting and creation of a phony auditing firm.

Wood River Capital Management failed to disclose to the SEC a conflict of interest with its investments. The firm invested 85% of its funds in a company that Wood River’s founder had a stake in, and that company’s stock crashed, wiping out the bulk of WRCM’s assets. Instead of a having a more diversified set of investments, in addition to risk-mitigating measures, Wood River misled investors and the SEC.

It’s clear, yet startling, how a hedge fund fail can purely from operations. Even some investment decisions are the results of operational failings, as some of the trades are either unauthorized by the investors or downright illegal.

What you should do:
Fund managers have enough on their plate dealing with investment management; operations management is another beast.

Due diligence being your guide, invest in a strong operations and compliance team, hiring staff of reputable background. Assign a chief operating officer and compliance director to ensure monitoring of the day-to-day activities.

Consider outsourcing for hedge fund operations as a way to reduce costs and increase workflow efficiency.