The hedge fund industry has a problem

The hedge fund industry has a problem: Some funds are getting too big.

That’s according to a Barclays survey, released this week, of 340 investors managing about $8 trillion in total.

The UK bank asked survey participants why hedge funds had underperformed expectations. The most popular answer was that the industry had gotten too big relative to the number of opportunities. The issue is likely that many individual hedge funds have gotten too large and are chasing similar strategies, which leads to crowding.

Here is Barclays (emphasis is ours):

“Across the various strategies, it appears that, on average, asset growth in the individual funds account for two-thirds of the overall growth by strategy while the number of new funds accounts for only one-third. This suggests that, on average, HFs are growing their [assets under management] quite considerably and that the bigger HFs are in fact getting bigger … the issue is likely not the growth in size of the overall HF industry, as there appears to be an ample supply of assets. The issue may be, however, the growth in size of many individual HFs, which are pursuing similar strategies leading to crowding.

The industry now has as many as 11,000 funds worldwide, managing about $3 trillion in assets.

It has had phenomenal growth from the early days when the business was a cottage industry. At that time, it was possible to start a fund with little more than some starting capital from family and friends — and, as the cliché goes, two guys and a Bloomberg Terminal in a basement.

The increased size of the industry has created two additional problems. First, observers have said, too many people have tried to enter the market.

Billionaire investor Steve Cohen has said he has had trouble finding talent for his family office, Point72 Asset Management, while Howard Marks, the cofounder of the private-equity firm Oaktree Capital Management, splashed cold water on the industry last month.

“The performance of the greatest hedge funds run by geniuses, and their closing, created a big umbrella over this industry, which permitted the other 9,990 hedge fund managers to start hedge funds and command hedge fund fees,” Marks said during an earnings call.

In other words, many not-too-talented people raced into the industry, and they might be drowning out the true talent.

Second, there is increased crowding. Here’s what Barclays had to say about the issue:

“While there are many advantages that larger [hedge funds] have (e.g., access to talent, institutional infrastructure, etc.), there are also several drawbacks. One such drawback is that as [hedge funds] become larger, their investable universe can often be diminished (e.g., due to position limits) as it is often not ‘worth it’ to invest in smaller situations that can hardly move the PnL needle.”

Crowding hasn’t always been a problem. In fact, piling in to popular names has traditionally been a winning bet. But since the tail end of 2015, indexes populated by crowded names have been dropping sharply, affecting a big chunk of the hedge fund industry.

*Correction: The original article cited a Barclays report as saying the hedge fund industry was too big because there were too many hedge funds. That interpretation was incorrect. Rather, the report said individual hedge funds may have gotten too large.

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