Doomsday Scenario for Hedge Funds

The $3 trillion hedge fund market could shrink by as much as 30 percent in the next three years, according to a new report from Boston Consulting Group (BCG).

This worst-case scenario, one of three possible outcomes the consultant projected for the industry, is what the group expects if hedge fund performance remains subdued over the coming years and investors continue to shift assets elsewhere.

Hedge funds, which have struggled to produce high returns in a low-yield environment, were outperformed during the last five years by stock and bonds markets, according to the report. Increased competition from other types of asset managers, including private equity funds, may make matters worse, BCG says, further diverting assets from hedge funds while eroding their fees.

In this scenario, not only would the hedge fund industry shrink “significantly,” but margins would fall 20 percent, according to BCG. A large portion of middle-ground hedge funds would be “wiped out” as remaining assets flow to the largest managers and niche firms. And average compensation for managers would shrink 30 percent, with bonus pay plunging and base salaries making up a larger portion of remuneration.

The report also describes two slightly more optimistic scenarios, in which assets under management either flatten or increase in line with historical averages. Both outcomes include investment performance returning to levels seen between 2010 and 2014 and asset owners maintaining current allocations to alternatives.

The better of the two – in which assets are projected to reach $3.5 trillion by 2020 – results if new opportunities in capital markets create new revenue opportunities, according to BCG. Middle-market hedge funds will still be “squeezed,” and margins will fall by 5 percent as the result of “modest” fee erosion, but large and niche managers will thrive, the consultant says.

Manager compensation would drop 10 percent as a result of lower bonus pay, but firm profits would be slightly up overall.

Alternatively, BCG said that assets under management could stagnate or decrease slightly if hedge funds are hurt by the same increasing competitive pressures described in the worst-case scenario. In this middle outcome, investors will “look to a few trusted hedge funds to meet targets” as market polarization “accelerates.”

Margins will drop 20 percent as the result of fee pressure and increasing capital expenditure, and manager pay would also decrease by 20 percent.

Given these largely bleak outcomes, the consultant offered advice on how hedge funds could succeed in the coming years. According to BCG, the “hedge fund of the future” will embrace technological advancements, place an “unprecedented focus” on investor needs, and “build an agile and scalable operating model” to increase efficiency.

“Hedge funds that can make these changes and achieve the required scale or specialization will be positioned to meet the coming challenges,” the report concludes.