Hedge Funds On The Defensive As Hugh Hendry Sees 80% Reduction In Size Of Industry

It is no longer fun being a hedge fund manager - first, up until the recent POMO-based rally in stocks, HFs were down for the year, and what is far worse, they were underperforming the broader market - a death sentence for pretty much every hedge fund, as this is proof a fund can not extract alpha and thus has no reason to collect 2 and 20. While the recent ramp in the market is welcome by all bulls, the question remains just how leveraged into the latest beta rally hedge funds have been. If after the nearly 10% rise in the past 2 weeks any individual HFs are still underperforming the market, it is a near certain "lights out." To everyone else: congratulations - you just bought yourself another 3 months of breathing room. Better hope the Fed makes good on its QE promises one day soon. In the meantime, Bloomberg Matthew Lynn and Ecclectica's Hugh Hendry both confirm that in these days of instantaneous liquidity demands, and cheap strategy replicators in the form of ETFs which provide the same beta capture as hedge funds, at a fraction of the price, it is only going to get worse and worse for the once high flying community. In fact, Hugh Hendry goes as far as suggesting that 10 years from now 80% of all hedge funds will be gone. Our personal view is that the target will be reached in a far shorter time frame.

On one hand, Matthew Lynn shows the uphill climb that defenders of the hedge fund industry have to pass in recent days. "An industry that doesn’t know how to defend itself, and has forgotten how to justify its existence, is in crisis. Hedge funds are now in that position." Hilariously, Lynn shows that hedge funds uses that good old staple used by HFTs to defend their own piracy ways and means: providing liquidity.

On both sides of the Atlantic, hedge funds have been busy trying to hold their own against the tide of fresh regulations sweeping through capital markets.

The Washington-based Managed Funds Association, the U.S. hedge-fund industry’s biggest trade group, has been campaigning against proposed curbs on high-frequency trading. That would, it says, reduce liquidity and increase costs for all investors.

Likewise, the London-based Alternative Investment Management Association is trying to hold the line against European Union regulations on short-selling. It claims selling shares you don’t own increases liquidity and aids price discovery, which means there should only be more transparency, not a clampdown.

Please, guys. This script just won’t work anymore. If you want to defend the industry, you need some new lines.

Can anyone seriously say investors are deterred from buying these stocks because the market in their shares isn’t liquid enough? Do we really need a lot of high-frequency hedge funds buying and selling their shares several times a minute to ensure there is a market in them? Of course not.

Likewise, short-selling. It’s perfectly legitimate in certain circumstances to short-sell a share. Occasionally, it will make the market a bit more efficient if there are more buyers than sellers. But again, none of the major markets is hard to trade. Nor are any of the big stocks really mispriced -- and, even if they were, it’s not much of a problem. If your sole contribution to humanity is that you help the share prices of large banks collapse over a morning rather than a whole day, it isn’t much of a justification for your existence.

Lynn summarizes what a credible, if improbable defense strategy may look like:

So, what the hedge-fund industry needs to do is start making a case that it is channeling funds to productive investment. It has to demonstrate that it is providing the capital that ultimately allows roads to get built, products designed, and jobs created. And it must show it is doing so in a more efficient way than banks and stockbrokers did 30 years ago.

How? If they were collecting money from the wealthy and investing it in industries or countries where capital is short, that would be a good argument. Or if they were creating markets in commodities or asset classes where none existed before, that would work. If they were smoothing out returns so people’s pensions were protected, or swapping currencies so they got cheaper mortgages, that would also make sense.

True, it may be impossible. The industry might well be a giant parasite that does nothing more than siphon vast wealth from the economy, while doing little in return.

But it should at least try. Just bleating about liquidity isn’t going to work. And if it can’t come up with a better way of justifying itself, it deserves to get hammered.

On the other hand, and making things even worse, you have a member of the hedge fund community itself, in the face of Hugh Hendry, who tells BBC that hedge funds "have reached a point where they've taken all the gains and it can only go the other way." And the most damning claim about hedge funds, and other asset managers in general: they are merely lucky (and in many case illegaly so) degenerate gamblers: "Overall it has been too easy to make money from financial speculation. I think that ease will disappear. I think that there are far too many hedge funds. I think the number of hedge funds could fall by a factor of 80% over the next 10 years. I think stock markets in 20 years time may be no higher than where they are today. House prices likewise. Try making money in that environment."

But lucky for hedge funds, they actually have a scapegoat for their underperformance in 2010 - High Frequency Trading. We fully expect that when the SEC completes its analyses of the May 6 flash crash in two weeks time, the blame for the crash will be squarely focused on the High Frequency Trading machine that has kidnapped markets. What happens next is anyone's guess.