The prolonged bull market is proving a big headache for hedge funds. In the first quarter of the year, hedge funds underperformed the market...

The prolonged bull market is proving a big headache for hedge funds. In the first quarter of the year, hedge funds underperformed the markets as a whole by a whopping 181 basis points. The Credit Suisse/Tremont Hedge Fund Index was up 5.46 per cent (January to March), compared with a rise of 7.27 per cent in the FTSE All World Index over the same period. And this is after a four year spell in which long only fund managers have consistently beaten the long/short managers – in some periods by a wide margin. Industry observers are agreed that the hedge fund industry is due for a shake-out – not dissimilar to what happened in the technology sector during the frenzy of the dotcom era when too much capital and too many marginal players were attracted by the unfulfilled promise of excessive returns. With over 7,000 hedge funds running more than $1 trillion, some see up to one in five hedge fund managers disappear. At the same time, there is likely to be a consolidation at the top end. According to consultants McKinsey, the top 100 hedge fund managers have already increased their market share from 49 per cent to 58 per cent between 2001 and 2004. A major factor in any shakeout is the undeniable fact that hedge funds are operating an unsustainable charging structure. With a base fee of 1-2 per cent of assets under management plus 20 per cent of any returns above a defined threshold, it is hard to justify paying such a huge premium compared with a long only manager typically charging only 40 to 50 basis points and delivering consistently superior returns. The charging issue is compounded when additional fees are paid to intermediaries for providing advice and access to funds of funds. The economics are causing a blurring of boundaries between hedge funds and traditional long only managers as the latter have increasingly begun to introduce leverage, long short and other “high octane” strategies in their quest for alpha returns on behalf of their clients. In this rapidly changing landscape, hedge funds will be faced with issues of identity and competitive positioning. It is remarkable in an industry that has grown so far in such a short period how relatively few names stand out as recognisable “brands.” Hedge funds have classically been a producer phenomenon - differentiated in a sophisticated customer market exclusively on the basis of their historically superior performance. Now that they can no longer claim the advantage of better performance and they begin to reach out more to the retail customer, the value of their brands will become increasingly self-evident. Just as manufacturers of grocery products have long understood the importance of brands in building relationships of trust with their consumers and their retail customers, hedge funds will come to realise the value of establishing a brand presence in the investor community – with wealth managers and their investor clients. As the hedge fund industry grows more concentrated and less clearly differentiated, one of the defining characteristics of the leading players will be their ability to develop and execute successful brand strategies.