Research shows that 5% of hedge funds went bust in 2005 [see Asset allocation: Hedge funds in M&A turnabout, this issue], and that figure is conservative given that these were funds that were transparent and therefore on the public radar screen. Such figures add to the belief that 2006 will be the year for sector consolidation.
With SEC registration leading to increased costs, and lack of volatility and opportunities impinging on returns, smaller hedge funds, particularly those running single strategies, will be forced to club together with their peers to form multi-strategy organizations. Pending consolidation among managers is not new news; what has not been considered are the implications for funds of hedge funds.
The pool of hedge fund managers from which funds of funds can choose will naturally diminish, making it harder for the funds of funds to convince end investors that they can add value. And as hedge fund managers club together, they become more professional and transparent, raising questions about the need for funds of hedge funds as providers of due diligence.
If funds of hedge funds want to stay in business, they will have to take a leaf out of hedge fund managers’ books and seek to diversify their business lines. One suggestion is that funds of funds will have to start running their own multi-strategy hedge funds alongside their current offerings. This would most likely be made possible by acquiring several smaller hedge funds, and so the strategy would be open only to larger cash-rich funds of hedge funds.
For medium-size and small funds of hedge funds, an alternative would be to focus on providing access to niche managers that end investors might struggle to find for themselves. Already several of these types of funds of hedge funds exist. But how long do unusual strategies stay unusual? It would require a constant search for new strategies and a high turnover of underlying managers.
There are almost 2,000 funds of hedge funds. Last year more than 7% of those were liquidated. If funds of hedge funds don’t spread their business risk soon, that figure could be much higher at the end of 2006.