Why Hedge Funds Fail ?

Hedge funds are considered to be the riskiest of all asset classes. Almost everybody considers hedge funds to be completely speculative in nature. Add to this the fact that Securities and Exchange Commission (SEC) allows only accredited high net worth individuals to invest in such funds and they start to look all the more suspicious.

Hedge funds have a reputation of being fragile and they do so for good reason. In a short 20 year span, the market has seen many hedge funds rise to prominent positions only to come crumbling down later. The average life of a hedge fund is 7 years! This is much lower than the average life of a corporation.

The most obvious reason given for this hedge fund debacle is that these funds take on too much leverage. However, research has unveiled many non-financial reasons behind the failure of these funds. In this article, we will look at some operational flaws that cause the hedge funds to fail.

Star Managers

The most obvious operational flaw is the presence of star fund managers. These are typically individuals who have earlier worked for global behemoths and are now partners in the hedge fund or at least a part of their senior management. Such a fund is therefore is not an organization that is attracting investments. Instead, it is the manager that is attracting these investments. Therefore in such a scenario if the manager quits the organization for certain reason, so do the investors. Many funds have seen huge withdrawals overnight as star managers walked out of the door. This is what has caused these funds to hire fewer star managers. Either they start demanding higher and higher compensation or they simply leave causing the fund to collapse.

Wrong Marketing

The business of hedge funds is prone to poor marketing. Of course, the marketing team has targets to meet and high pressure tactics are employed. But often, the fund is sold to the wrong type of investors. A hedge fund is also prone to market cycles and given the leverage that they employ, the effect of these cycles may be deeply felt at such funds.

However, the marketing team often paints a false picture in front of the investors. They claim to have developed some sort of risk monitoring mechanism wherein they can provide maximum returns with minimum downside. This attracts the wrong class of investors who desert the fund at the first sign of trouble.

A hedge fund is a risky investment. It is meant for people who have the appetite for such risk. Selling it to risk-averse individuals will only cause rampant withdrawals as soon as the fund hits a downturn.

Poorly Conducted Operations

In many cases, the entire firm is run by a former fund manager. Such people are excellent at picking out the right stock which will give them maximum returns. However, such funds are not good at controlling the day to day costs being incurred. Also, such funds are not good at evaluating the use of technology and bringing about process improvements which lead to lower costs and higher productivity.

It is for this reason, many hedge funds do earn handsome returns but their loosely handled operational costs devour their profits. Many funds have already fallen prey to this. For this reason, most hedge funds nowadays hire professional managers to manage their day to day operations. Hedge funds are about picking the right investments. However, like any other business, they also need to keep their costs as much under control as possible.

Lack of Partnerships

Many failing hedge funds have discovered that the right partnerships may hold the secret to survival. Hedge funds are marketed based on perception. So, if a hedge fund has to survive and thrive, it must cultivate the right partnerships with analysts who shape such perceptions.

Also, mega corporations like JP Morgan Chase, Bank of America and Credit Suisse provide their brand names to these funds for a fee. Striking an alliance with these huge corporations also improves the funds perception. These factors combined with a consistent performance can help the fund stay afloat for a long period.

Differential Pricing

Lastly, many funds employ differential pricing for their customers. They charge one set of fees and commissions to certain customers. However, when large investments are made, a significant discount is offered to the investors.

Smaller investors believe that this is unfair and many quit the organization as they do not want to allow large investors to take unfair advantage. This line of thought is supported by individuals who believe that bigger does not necessarily equal better suggesting that the fund should not blindly seek more investments as it may lead to a suboptimal return for all parties.

The Compensation Problem

Hedge funds are often criticized for paying their employees too much. However, these humungous salaries are not a choice that such funds make. Instead, they are a compulsion. If the funds pay too less, many employees desert these funds are start their own ventures causing the funds much more than it would have cost to pay them a bonus.

The strategy of paying minimum salaries to the employees in order to maximize shareholder return has led to the downfall of many funds.