Recent data show a growing number of fund closures across the alternative sector. Not surprisingly, the main damage is among the smallest funds. A quarter of those with assets of less than $50 million have shut down since 2011. Realistically, unless a fund of this scale operates in a well-defined niche, as part of a larger business proposition, there is little economic justification for its creation, let alone its survival. But of more concern is the fact that around 11% of the $500 million-plus fund population has been closed. And the core reason appears to be economic rather than performance related, albeit some born-again traders have found the sector more challenging than their former prop desk environments.
The reality is that a $50 million fund generates a million dollars of revenue a year, excluding performance fees, whilst a $500 million one will generate around $10 million, assuming, in both cases, the classical standard fees can be applied. And one should not overlook two critical factors. First, despite an improvement in the last 12 months, the performance, and therefore performance-related fees, of the alternative sector on average has been far from stellar. And, were one to extract the top quartile of performers, the absolute value generated by most of the sector is, to paraphrase a famous super-model, hardly worth getting out of bed for in the morning. The second is that we are experiencing a massive increase in fixed costs, which is undermining the business logic of a large swathe of the alternative population.
The main driver for fixed cost increases is that old bugbear, regulation. I have long argued that regulation is becoming unmanageable and that the quantum of rules being produced across the sector will lead to inadvertent non-compliance by even the most thorough of funds. Andrew Haldane of the Bank of England recently added his voice to those concerned about the challenge of the growing mountain of regulation, especially in the U.S. and EU. The statistics are often quoted and compared with those halcyon days, when the 35 pages of Glass-Steagall were a U.S. risk officers main bible. Today that same risk officer, often with a global role, has to delve into each paragraph and footnote of some 8,000 pages of rushed legislation and related rulebooks produced by the financial markets mega growth sector, the regulators. We live in a world where the number of regulators per financial sector employee has, in the U.K. alone, moved from one per 11,000 to one per 300 over the last three decades. Soon we could all have our own personal regulatory mentor!
But regulation is leading also to a transfer of risk from investor to the fund and, more worryingly, the fund administrator. The wording of EU regulation on cash management is a prime example of this. There, the administrator is being transformed from the secondary line of control, in fact a validator of the process adopted by the fund manager, to an equal partner with the manager as the primary controller. Elsewhere, regulation is requiring the custodian to become the effective guarantor of performance of their sub-custodian network, especially in the admittedly unlikely event of a sub-custodian default alongside a failure of the relevant jurisdiction to prevent seizure of a funds assets as part of the stricken banks resolution regime. And controls that have always been in place, such as an administrators duty to ensure compliance with the fund prospectus, are changing. In many jurisdictions, the regulatory interpretation of that requirement is moving from the mechanistic to the judgemental. Effectively, where historically the administrator would ensure that leverage limits, single investment limits or instrument selection were compliant with fund terms, now there appears to be a view that the reasonableness of the investment strategy may fall within their remit. Such flawed thinking would make them a strategic partner of the fund manager in portfolio selection.
The reaction of administrators to this changed environment is hard to gauge as we are still at the stage of verbal skirmishing. But, it would appear logical for several trends to emerge. If they have to intensify controls, more administrators will eschew the smaller funds as they will not be able to generate adequate returns. Many will eschew complex strategies, especially where cash flow is a major intraday dynamic that will be difficult to monitor. And they will avoid funds that specialize in too exotic markets, especially frontier ones where regulation is untested at best and unclear at worst. That is one of the reasons why administrators, despite increased risk, will fail to improve their returns. They will all chase the major funds for compliance oversight, and management is a fixed cost driven by fund structure and internal control more than fund scale. And the general oversupply in the industry will increase as the incumbents chase after a lesser number of bigger-ticket deals, where powerful buy-side wallets mean those margins will continue to be challenged.
It is likely that shrinking the number of funds and fund groups is an intended consequence of much of recent regulation. Scandals do not need mega fund groups; smaller funds can create problems that have political repercussions. And in reality, more than ever, regulation is about protecting the public purse from the results of delinquency in financial markets and the politicians from the taint of scandal due to regulatory failure. And, as ever, helpful deep pockets at the fund management company and fund administrator level are seen as valuable safety nets to meet investor claims for real or perceived failures in investment strategy or control. The future remains challenging!