In the spotlight

Hedge fund managers who earned more than $1 billion last year, including George Soros and Philip Falcone, have been summoned to Capital Hill today to testify under oath about the potential risks their firms pose to the broader economy. The hearing before the House oversight committee, headed by Democrat Henry Waxman, marks one of the few instances in which the largely unregulated hedge fund industry will be subject to questions by lawmakers. Expect lots of hand wringing on tax and remuneration, and loose commentary on systemic risk.

Most will avoid what hedge funds like to call the macro picture. There are just too many of them. This year’s crisis in financials had a simple cause: the world was over-banked. Ditto hedge funds. The universe of funds – including funds of funds – has expanded from just over 600 in 1990 to over 10,000 today, according to estimates from Hedge Fund Research (HFR).

Many are pursuing the same trades, thus eroding each other’s returns and exacerbating the effects of forced sales. Quantitative strategies – crunching data to unearth relationships between securities that hold true over time – are particularly crowded, thanks to a proliferation of off-the-shelf packages. HFR’s data suggests that funds did best in the early 90s, when the industry was about a tenth of its size today, both in numbers of funds and total assets under management. The average yearly return after fees was almost 19% in the 90s; so far this decade, it is less than 9%. 

Capacity is gradually being removed. The total number of funds was down about 2% from the second to the third quarter, but has some way to go. Industry bigwigs say that up to a third of funds could vanish. Any strategy depending on the magic ingredient of leverage to turn basis points into percentage points is a prime candidate for extinction. Judging by the changing tone of letters to investors, many managers suspect that the game is up. The euphemisms that abounded earlier this year (your fund “eased” 5%) are giving way to unabashed appeals for clemency.

This is why Washington needs to be careful. Putting pressure on fee structures or setting up some kind of ineffective regulator could confer legitimacy on many “me-too” operators. It could also lead to precisely the wrong outcome: more funds staying in business.