Why Do Hedge Funds Fail?

April 22, 2020 - Stephen Van de Wetering

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 through 2019, the losses began to mount. 

Despite the pullouts and shutdowns, hedge funds managed to return 9% in 2019, compared to losses in the prior year.  Even amidst the COVID-19 outbreak, hedge funds outperformed the stock market in March. 

While there may be some good news, plenty of challenges will remain in the current investment climate.

As a hedge fund manager, you must prepare for headwinds and expect the unexpected. How you handle those 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 breaking 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 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.  

Despite the 9% gain in 2019, the S&P 500 Index returned 32% in that same stretch. This underscores a trend since 2009, in which hedge funds have perennially underperformed against the S&P 500. 

At a certain point, dissatisfied investors will move their assets to better performing managers or go to passively managed index funds. 

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:

Spend more time on investment research. Improve your ability to identify trends and opportunities before others see them, and improve your ability at timing, knowing when to jump on and off the “bandwagon.” 

Think about how COVID-19 has impacted previous understandings of investing and economy. Researching allows you to better understand a world that is dealing with the pandemic and a world that will emerge after it’s over. Through this knowledge, one can place investments accordingly and with greater confidence. 

If non-investment related work is preventing you from fully focusing, then delegate tasks to competent third parties. This will free up capacity to allow for more time on research, and with this extra capacity, it may be helpful to let your investors know you’re outsourcing

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’.

Stay focused on performance, and let the performance do the talking when attracting assets.

Conclusion

Hedge funds don’t have to fail, but they often do because of operational issues.

Employing the right people and strategy will mitigate a lot of that risk. Competent and ethical individuals, whether in-house or third-party, will carry out the strategy and not succumb to the misdeeds of a Bernie Madoff, Bayou Group, or Wood River. 

Poor investment choices and excess risk exposure can lead to underperformance, thus additional reasons hedge funds fail; COVID-19 won’t make things any easier. Fund managers need to free up their capacity to focus on research, increasing their investing acumen and foresight. 

Furthermore, put yourself in the investors’ shoes. Are your fees justified? To what extent is your success as a manager determined by the performance of the assets, as opposed to attracting assets to the fund? 

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