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.

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.

4 Reasons Hedge Funds Fail

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:

Now think of everything that can go wrong:

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.

Bad investments; too much risk exposure

Firms that trade heavily on margin run a severe risk when the market misbehaves, and putting too many of your clients’ eggs in one company or industry basket, especially if these are volatile securities or sectors, is flirting with disaster.

What you should do:
To avoid trouble, your firm should set leveraging limits, maintain a standard minimum level of liquid assets, have a healthy mix of high- and low-risk investments, and perform stress tests. In addition, be transparent with investors and governing bodies.

Be upfront about risks and conflicts of interest, even though you might lose investors or receive a smaller share of assets, but your career and reputation are more important than a short-term gain with long-term consequences.

Underperformance

Hedge funds have had trouble outperforming traditional benchmarks. According to Hedge Fund Research, a fund’s average return in stocks was 7.2% annually from 2009 to 2017, which was less than half of the S&P 500’s return.

At a certain point, dissatisfied investors will move their assets to better performing managers, or they’ll stay out of hedge funds altogether.

What you should do:
Perhaps your underperforming if your time is consumed by non-investment work (administrative affairs). If you delegate tasks to a competent operations team, that may give you more time and peace of mind to focus on research and strategy.

Fee structures

Poor performance being a catalyst, there is increasing pressure on the traditional 2-and-20 model, the revenue structure in which hedge fund management fees are derived from 2% of overall assets and 20% of profits.

Critics, including Warren Buffett, say this fee structure doesn’t provide enough incentive for hedge fund managers to perform well. If the overall managed assets grow, emphasis on 2% of assets will outweigh the motivation to pursue 20% of profits.

In recent years, hedge fund management fees have been falling, a sign that investors demand fees that correlate more to performance and profit rather than merely managing assets. At the same time, lower fees reduce a firm’s profit margins in the absence of high performing investments.

What you should do:
Talented fund managers can make a case to justify their fees, but whatever your structures are, make sure your interests align with the clients’.

Conclusion

As the number of assets managed in hedge funds reaches an all-time high, the future looks good for the industry.

But it’s shocking how even before considering pure and innocent investing, so much can go wrong because of operational failure. Many of the risks can be mitigated or avoided by investing in a world-class operations.

When it comes to investing, put yourself in the clients’ shoes. Are your fees justified? To what extent is your success as a manager determined by the the performance of the assets?

All in all, it pays to play by the rules.