Hedge Funds and Institutional Behavior

Yesterday's WSJ had an interesting article about what it calls a "brutal shakeout" in the hedge fund industry.  It asserts that smaller hedge funds, even those with good records, are finding it difficult to grow and are even being forced to close, and that it's getting more difficult to start new hedge funds.  Conversely, the largest hedge fund groups, like D.E. Shaw and Och-Ziff, are attracting a growing share of hedge fund investor capital.

Why?  The article offers the following reasons:

• The bigger funds have better risk management--they preserve capital better in down markets.
• Large institutional investors are reluctant to invest in smaller funds because they lack the client service capabilities of the larger ones, the brand names of the larger funds, and because  . . . well, because they're "simply too small."
• Smaller and newer hedge funds have more difficulty arranging the large prime broker financing upon which so many hedge fund strategies depend.

The larger point the article makes is that the hedge fund industry's main customer has changed:  It used to be taxable individuals and families investing their own capital.  Now the main "customer"--i.e. the one who sets policy at the margin--is an employee of a tax institution like a pension fund.

Where you have institutions, you'll find institutional behavior.  This manifests itself in certain "business" ways--i.e. in hedge fund managers' indifference to the tax treatment of their gains, which the article alludes to ("If my largest customers don't care about taxes, I won't either").  But it's also a psychological phenomenon: a pension fund employee investing other people's money, who works for a salary and has a job to lose if something goes wrong, and who is likely part of a large committee setting investment policy, will behave much differently than an individual hedge fund investor.  That's why you see the emphasis on brand names and on size, and on risk management even in the short term.  To the pension fund employee, a 10% loss in a D.E. Shaw fund will hurt much less than the same 10% loss in a small fund no one's ever heard of.  In the latter case he'll likely get fired.  In the former case he'll keep his job because at least he's in good company with the many others who invested in the megafund.  To quote Keynes:  "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

This "institutional effect" must be very powerful because on the performance side, there are huge diseconomies of scale in money management.  A fund running $100 million has a huge natural advantage over a fund running $10 billion because in the former case the universe of things to look at is so much larger, as is the ability to accumulate meaningful positions in your best ideas.  Buffett has famously said that if he were managing $1mm, he could compound it at 50% a year.  If I were looking at hedge funds and all I cared about was long-term outperformance (which is all I'm supposed to care about) then I would almost make it a point to rule out large funds.  The fact that the industry in aggregate is doing the opposite is therefore very telling.

For this blog's target reader--individuals and family offices with the means to invest in hedge funds--the larger point is that the hedge fund industry as a whole is moving away from you.  You're no longer the main customer: the main customer is someone else who thinks differently than you do.

Fortunately, that doesn't have to be a bad thing.  In fact, it can be very good.  If the industry is zigging then you can zag:

1. If institutions are forced to stay away from small non brand-name funds, seek out the non brand-name funds.  You'll have less competition for investment dollars, meaning you can invest more dollars per unit of investor talent, which is the name of the hedge fund game.
2. If new hedge funds are having difficulty starting up, then turn yourself into a hedge fund incubator.  Again, you'll have very little company.  And you may even get a crack at the Holy Grail--part ownership of the hedge fund management company.  There's no better way to turn your father's money and someone else's hard work into a giant bonanza (I'm looking at you, Ziff Brothers!  I'm looking at you, Nat Rothschild!)
3. If everyone else has to care about short-term volatility, to the point of worrying about how many down months a fund has, then seek out funds that earn higher returns with more volatility, but which don't run the risk of permanent capital loss.  You're investing for your grandchildren, what do you care about next month?
4. If most funds ignore taxes, seek out that lonely minority of fund managers who do care about taxes.  These are likely to be those who are investing their own net worth alongside you, AND who aren't trying to raise as much capital as possible from institutions.  In other words, managers whose main customer is just like themselves. 
5. If smaller funds have more difficulty arranging prime brokerage financing, then seek out those funds that don't depend on prime brokerage financing--you won't hear about them from the traditional source--the capital introduction units of the large investment banks, because these funds are such bad customers of Wall Street.

It's no coincidence that my favorite kind of hedge fund strategy, concentrated value, fits all of the above.