We live in an equity culture. Perhaps it is because of the the legacy of the 401k, or the cultural influence of Peter Lynch, Warren Buffett the media focus on hi-growth technology enterprises like Microsoft, Intel, Ebay and Google. In any case, the gross majority of adults in this country own stocks of one kind or another, through a variety of brokerage, retirement and college savings accounts. The most convenient mechanism for investing in the stock market remains mutual funds, which typically charge a fee based on assets under management (AUM).
Despite a stellar 2003 where most mutual fund performance mimicked those of the broader indices, retail investors have come to question the credibility of some of the largest mutual fund complexes. This has come in the wake of Spitzer lawsuits against market timing and directed brokerage arrangements as well as the lingering effects of the bursting of the technology bubble in late 2000. Certain funds such as Fidelity and T Rowe Price seem to have managed to keep their reputations in tact, others such as Janus and Strong are working hard to rebuild their brand equity.
In the face of legislation, lawsuits and media criticism, mutual funds have become significantly more cautious. They can't afford to become associated with any more scandals or be on the wrong side of any potential legislation. Mutual funds continue to lose their most successful fund managers and research analysts to unregulated hedge funds where such managers and analysts can make far more money with far less scrutiny. As if the brain drain wasn't bad enough, mutual funds can no longer (by virtue of their huge asset bases) command proprietary information from companies since Regulation FD mandates that all investors receive material information concurrently.
One would expect that mutual funds would take this opportunity to reinvent themselves and distinguish their products through innovative research strategies. Ironically, however, mutual funds seem less willing to try new forms of research than ever. Structurally, there has been a virtual, self-imposed ban on soft dollars within the mutual fund industry. Mutual funds suggest that they will pay for independent research through their management fees, but in reality they would prefer to pay directly through trades to the proprietary desk of the research provider. The only problem is that most of the emerging value-added independent research providers produce innovative research as opposed to provide trade execution. The firms that the mutual funds are comfortable trading with (and thereby willing to purchase research from) remain the same large sell side institutions that have been replacing their equity analysts with in-house proprietary traders, who actually compete with the mutual funds themselves.
Against the backdrop of these challenges, hedge funds continue to acquire assets, track records and brains. In the last few weeks alone, I have heard of one fund that has just passed $1b in assets from only $100m about a year ago; another fund that has gone from $600m to north of $2b in 12 months; and a new hedge fund that just launched with north of $3b. There seems to be no shortage of institutional capital available to the best or most promising hedge fund managers. Risk management technologies and portfolio reporting platforms provide a level of comfort and transparency that has created enormous liquidity among funds of funds acting as intermediaries between single manager hedge funds and family offices, pension funds and endowments. Hedge funds would seem to be happy to ignore the average retail investor and focus exclusively, in perpetuity on institutional investors.
But then I heard something that surprised me. One hedge fund manager that I have enormous respect for shared the basic fact that he rarely makes money on the short side but maintains a hedged strategy because of the 2 & 20 fee structure that he is able to charge. His argument is that he could make less than 1% of AUM with a long only strategy and as much as 5x that with the same long book with a few short positions (even if they aren’t what’s contributing to the performance of the fund).
The second incident that caught my attention was the open rumor that a very large, very sophisticated, and very secretive hedge fund had tried to acquire the assets of a well-known mutual fund complex that had run across difficult times.
The third point in this nexus is the fact that Bill Miller, the legendary manager of Legg Mason’s mutual funds and certain portfolio managers at Fidelity have begun to utilize short positions as well as their long positions in a modified mutual fund meets hedge fund strategy.
And so when I synthesized these trends in my mind, I realized that it is inevitable for the line between hedge funds and mutual funds to become more and more vague. It is only a matter of time before the best mutual funds begin offering premium hedge fund-like strategies (with higher fees) for their top retail customers. At the same time, as certain of the savviest and most institutionalized hedge funds grow beyond their somewhat narrow professional investor base, they will likely acquire and/or merge with existing mutual fund franchises in order to acquire retail investment assets. One thing that has always plagued hedge funds has been the lack of long term equity value. You are only as good as your last year, as it were. With a mutual fund apparatus (and the long term brand equity value it might bring), perhaps hedge funds could establish equity above and beyond the presence of their founders.
As I look out over the next few years, here are some of the consequences that seem to be natural outcomes of these developments:
• Everybody (individuals and institutions) will be able to have their money managed by top hedge fund managers.
• As hedge funds, new long/short mutual fund strategies, and internal funds within banks start functioning more and more as a single asset class, the costs for investors will find a standard rate (2% of AUM and 20% of upside)
• Investors that are not willing to pay the market rate for sophisticated money management, but who do not want to actively manage their own portfolios, will likely simply opt for index funds which may replace traditional single manager mutual funds as the mass consumer investment instrument of choice.
• Funds with north of $1b will be forced to trade in the same crowded names because the number of equities of adequate liquidity is not growing nearly as fast as the funds are (ie hedge fund strategies will proliferate faster than the number of unique, tradable equity ideas available)
• The best opportunities for investment performance will reside in smaller, undiscovered hedge funds that have yet to break $100m in AUM and remain below the radar of fund of fund promoters. Same phenomena as signing Maroon5 when it was playing lounges in LA or Pedro Martinez when he was throwing coconuts in the Dominican Republic. Only these smaller funds will have the flexibility to move in and out of positions in smaller cap names and truly outperform the indices.
• The next generation of the sell-side will take its cues from the current experiments of independent research firms and direct access electronic trading platforms. The most successful sell-side firms will marry outsourced data acquisition and information analysis with electronic trading to become underlying, enabling operating systems for the buy-side to collaborate with and compete against itself.
• As trade execution and traditional equity analysis become commodities given away for free, the value of proprietary trading strategies and exclusive data will rapidly increase.
• The next generation of great Wall Street franchises will be created by software developers and information brokers rather than by equity analysts and sales traders.