No one will miss the hedge funds

Hedge funds appear to be in terminal decline. Matthew Lynn explains why the markets will be a healthier place without them.


A welcome trim for the hedgies

Hedge funds have defined the financial markets for the last 15 years. But after years of dismal overall returns, they now appear to be in terminal decline. According to a report from Barclays, the total number of funds is now falling for the first time, apart from a dip during the 2008 financial crash. The total number of funds is expected to drop by 4% this year, to slightly over 10,000.

There have been some high-profile closures from managers such as Fortress, and Laurion Capital Management. Other funds have closed their doors to new investors. One analysis by Blackstone suggested the industry could lose a quarter of the $2.9trn it has under management over the course of this year, through a mixture of poor performance and investors pulling out.

There are plenty of reasons for that. The sector has become over-crowded, with lots of mediocre managers chasing the same strategies. The bigger funds have become too large to deploy their capital successfully. The markets have thrown up far fewer opportunities for the kind of niche strategies the hedge funds were good at exploiting, while lower-cost alternatives, such as exchange-traded funds, have started to emerge.

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But we shouldn't mourn their passing. It will be better for markets. Hedge funds charged huge fees typically 2% of the assets under management and 20% of any gains that were made but there is no evidence they generated above-average returns overall to justify that.

Indeed, the vast amounts of wealth they generated for their founders had to come from somewhere, so in total they became a net drag on the market. It is hard to see any evidence that they improved the way money flowed through the capital markets, or created anything new, or deployed strategies that meant money was provided to projects or companies or entrepreneurs that would otherwise have found it difficult to raise any cash.

Neither have they improved investment returns overall. Indeed, since the hedge funds rose to prominence, the returns from the financial markets have been below their long-term averages it would be wrong to blame them for that, but it does suggest they weren't fixing it. They didn't reduce volatility indeed, given some wild swings in sentiment, and the rise of "flash crashes", they may actually have increased it.

Not only did the funds not do much good. In many ways, they were actively damaging. They created the impression that capitalism was all about trading existing assets, rather than creating new wealth. For the rich list to be dominated by speculators, rather than entrepreneurs creating new products and jobs, only helped confirm the worst suspicions about a free-market economy. They sucked up a lot of talented brain-power.

It's hard to blame 30-something MBAs for wanting to work for them but in fact their skills would have been far better deployed in a tech start-up instead. And their frenetic trading almost certainly made the markets more volatile and so, over time, made them less attractive to real investors, who were putting savings and capital to work.

It remains to be seen what happens to the 10,000 hedge funds still out there. A few will survive and even flourish if they can make better than average returns. But a lot more will gradually wind down as their investors drift away, and it seems unlikely that many more will be launched. A few divorce lawyers aside the hedgies were known for their spectacularly expensive marriage breakups it is hard to believe anyone outside the industry will miss them. The markets will be a healthier place once they are gone.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.