Earlier in March, major hedge fund Eton Park Capital Group announced its decision to close and return its capital to investors. This decision comes as somewhat of a surprise to those following financial markets, as Eton Park was regarded as one of the larger and more successful organisations in the industry.
A Success Story Initially
The firm was headed by Eric Mindlich, who gained notoriety in the world of Wall Street by becoming the youngest ever partner at Goldman Sachs at the age of 27. At its peak, Eton Park had some $14bn in assets under management (AUM) and was posting consistent returns of 10-20%. However, since 2011 the group has struggled greatly, losing almost half of its value. Most recently, in 2016, Eton Park posted a loss of almost 10%, which likely had great influence on its decision to shut down permanently.
This result in part reflects the overall state of the hedge fund industry. Well-known investors such as Warren Buffet, Steven Cohen, and Daniel Loeb have attacked the industry’s traditional “two and twenty” compensation model, suggesting that investment fees are unsustainably high and that the market is oversaturated.
Additionally, 1057 hedge funds were closed or liquidated in 2016, bringing the total number of active hedge funds to its lowest since 2012. Another well-respected hedge fund, Paulson & Co. posted a 16% loss in its event-driven fund for the 2016 fiscal year, further demonstrating the industry’s struggles.
What Is a Hedge Fund?
To be able to analyse hedge funds, it is important to understand what exactly it does. The hedge fund is an easily recognisable term – almost everyone has heard of it in the context of wealth and Wall Street. But a startlingly small percentage of people truly understand how they work.
At its core, a hedge fund is a private investment fund that markets itself almost exclusively to wealthy investors. These are aggressive, risk-seeking investment funds that attempt to utilise leverage in order to increase returns. This definition contrasts with the original meaning of the term – an investment fund that would pool capital together and “hedge” against risk while providing above average market returns, but is a better reflection of the industry as it currently stands.
Hedge funds typically specialise in different investment strategies, most notably Macro, Equity, Multi-Strategy, Relative Value, CTAs Credit, Event Driven, and Niche Strategies. Macro and equity strategies are the two largest, with some $955bn and $822bn in industry assets, respectively. There are a few different business models for how they work, but a common method is the general limited partnership model.
While there are a few different variations of this, this is a common industry practice. The industry standard for compensation is the “two and twenty” structure, where managers receive 2% of net asset value managed and 20% of profits. While these are relatively high percentages, one redeeming quality of hedge funds is that investment managers often invest their own capital into the firms. On some occasions, this can be as high as 50%. Many times, the salary of managers is dependent on positive returns on the investors’ capital. Both of these provide an incentive for performance from the fund.
Is This the End?
The hedge fund industry posted only a 7.4% return, and a net 2% of investors withdrew their investments in 2016. Some experts argue that this return is solely due to the appreciation of the different investments and point out that this is the first year in a while that there were overall more withdrawals than deposits into funds, further highlighting the struggles.
Despite the struggles, this may simply be that this is a rough patch for them. It has not been the first time in its relatively short history that the industry has struggled and a 2% net withdrawal is not great, but still a small number.
Additionally, the investor base of hedge funds has evolved a great deal since its beginnings. While originally mostly utilised by wealthy individuals, now 64% of US industry assets are held by institutional investors like pensions funds, endowments, and foundations.
So, while a fair number of hedge funds have had their struggles in recent years, they continue to play an increasingly important role in society. As much as the criticism of hedge funds surrounds the compensation model, perhaps this is really a question of adjusting it. Whether or not this is the case remains to be seen.