Hedge Funds Destruction by Regulation was Surely Not the Intent?

The seemingly endless stream of famous hedge fund strategies closing and many funds turning into ‘family offices’ continues. The latest change is at Lansdowne. Recent performance issues appear to trigger recent hedge fund closures in most cases, but is performance merely the catalyst? UCITS funds do not usually shut after just a year or two of weaker performance, nor do markets. It takes a much longer period of sustained under performance to do the damage. So what is going wrong?

The hedge fund model of revenue participation in upside is frequently characterised as greedy and unprincipled. The voluble complaining constituency is often the same group that claims compensation of senior corporate executives does not adequately reflect incentivisation to align investor-shareholder and executive interests! So, the assumption goes, hedge funds are closing simply because they are not making enough money when their performance is weaker. This is far too simplistic.  Most hedge fund costs are covered by fixed fees, even if those costs have been rising.  Committed hedge fund traders will not usually lose faith in their ability to generate returns because of one bad year. Many hedge funds have had periods of poor performance in the past without feeling the need to shut down.

So why the change now? The answer is that the hostile regulatory environment is causing two different sorts of challenge. First, the cost of on-boarding and servicing external clients has risen sharply as requirements have become more complex and the process tortuous. The second effect is fear of litigation. We live in a world where regulators are treated by the media as moral hazard underwriters, accused of incompetence every time retail investors lose money (think Woodford or mini-bonds). Naturally, regulators will respond to public pressure with tougher supervision and control of those they regulate, monitoring every step in ever greater detail, paralysing hedge funds. The net result is fewer hedge funds, and interestingly, closure has not been restricted to smaller funds, many large names have shut.

Shrinkage of the hedge fund sector leaves less choice for institutional and retail investors alike. Whatever happened to the right to be a contrarian investor and deliberately invest in under-performing strategies?  If those strategies are closed as soon as they under-perform there is no such opportunity. Return is only one measure of investing, diversification to achieve lower overall volatility is usually another. Hedge funds, even during times of poor performance can offer diversification, especially from a world increasingly dominated by index ETFs. Control of choice resulting in less choice, is that really a desirable policy objective?

The role of hedge fund principal is not one that engenders much sympathy. Single-minded and often ruthless pursuit of wealth is not a popular cause. Nonetheless regulation leading to a massive shrinkage of the hedge fund industry and of investor choice seems the wrong direction of travel for public policy. Regulation should empower and enhance an industry through the imposition of fairness and confidence, not lead to its destruction.