It may be the end of hedge funds as we know it

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finance.yahoo.com

By Bob Bryan

There's a colloquialism that hedge fund managers are "masters of the universe."

These investors take big risks betting on the market, but the reward has usually been pretty significant.

Let's not forget, five hedge fund managers made over $1 billion in 2015. 

Based on recent outlooks, however, the reign of these "masters" may be coming to an end.

Everywhere you look, it appears that doom and gloom is surrounding the industry. From competitors to analysts and even to the managers of hedge funds themselves, everyone is acknowledging that these funds are going through a rough patch.

It's all over

Let's get the obvious out of the way: hedge fund performance is abysmal. Funds are underperforming their benchmarks and many are losing investors money. For an industry that is founded on the idea that it can produce alpha, or better returns than the broad market, even being in-line is a disappointment.

Hedge funds typically charge high fees to deliver the alpha to their investors.

When they're not performing, more attention is paid to these fees. That focus has coincided with the growth of lower cost alternatives, such as liquid alternatives, which provide hedge fund-like investments with lower fees.

Add that up and you've got some problems. Tony James, president of private equity giant Blackstone, told Bloomberg this week that he expects a quarter of all current assets in hedge funds to be yanked out in the next year.

"It’s kind of a day of reckoning that we face here,” James told Bloomberg TV. “There will be a shrinkage in the industry and it will be painful. That’s going to be pretty painful for an awful lot of places.”

A 25% drop in assets might sound pretty dramatic, but there are those who think it may be even worse. K.C. Nelson at alternative investor Driehaus Capital Management, expects a brutal reduction in the number of funds over the next few years.

"I believe there will be a culling of hedge funds like we've never seen before," he said in a letter to investors. "I'd estimate the number of funds gets cut in half over the next couple of years."

Even Dan Loeb, manager of the hedge fund Third Point, said that it has been "one of the most catastrophic periods of hedge fund performance" and that many funds won't survive.

"There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies," he said in a letter to investors in April.

Now questions are being asked about the entire hedge fund business model.

According to Brian Balter, CEO of Balter Capital Management, the model has broken down, and there is nothing to do to repair it.

"The mechanism to grow a hedge fund broke, the hedge fund capital raising mechanism broke," he told Business Insider.

Balter, whose firm runs a fund of funds and liquid alts strategy, said that hedge funds start by getting seed money from a high-net worth family office. Then the fund-of-fund community would help build the fund from there, until the hedge fund became institutionally viable and larger pension plans would invest to grow it even further.

Now, according to Balter, there is such a proliferation of hedge funds that many family offices are skeptical of investing because they aren't seeing the growth.

The middle ground made up of fund-of-funds is also struggling, or in Balter's words "D-E-A-D, dead" and receiving redemptions.

Finally, pension funds from California to New York are starting to pull their money out of hedge funds.

"It's over for hedge funds," said Balter. "Yes, there will be hedge fund-like structures, but this is not a cyclical thing, it's a secular thing that has been been building up for a long time."

This too shall pass

To some in the industry, however, all is not lost. Many hedge fund managers have said this is simply a cyclical event and a case of too much attention being lavished on hedge fund performance.

"Today's reports of hedge fund redemptions totaling $15 billion in Q1 2016 might sound like a big shift in favor from the sector, but it is important to note that this represents only around half of one per cent of total AUM invested," wrote Jack Inglis, CEO of the hedge fund industry trade group Alternative Investment Management Association in a recent blog post.

"Outflows from equity and bond mutual funds over the same period have been much more."

Inglis also noted that hedge funds have outperformed most other investment strategies over the past 25 years, so to take the short-term view would be unwise. 

This may actually be a good thing

The thing is, the closure of many hedge funds may end up being a good thing for managers in the long run. Not for all managers, obviously, but for those that can make it through the tough times.

Currently there are a large number of hedge funds. In a June 2015, a report showed that there were a record 10,149 registered hedge funds. The staggering number of funds has "polluted" the returns of hedge funds, said Balter, as all of these big-time firms chase the same ideas.

Steve Cohen of Point72 Asset Management has decried the crowding of trades by hedge funds, making it impossible to anyone to generate returns.

So whether you call it a "culling" or a "washout", decreasing the number of funds investing could allow the survivors a little more elbow room to operate.

Only time will tell.