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According To Citi, Small Hedge Funds May Have No Choice But To Become Paper Traders On Twitter

Central planning has not been kind to hedge funds: six years after the Fed's great experiment to control and tame capital markets (which with every passing day is drawing closer to its unpleasant ending), the bulk of hedge funds have continuously underperformed the S&P. We noted his most recently last November:

 

 

In December things did not improve and in fact ended even worse, when every single hedge fund was positioned for a Santa Rally, only for the month to close red with a big selloff in the last few days, crushing the hopes of so many 2 and 20ers to finally book that Hamtpons' mansion with the last few days of trading. Bloomberg adds that hedge funds returned an average of 1.4% in 2014, their sixth straight year of underperforming U.S. stocks, and the worst since 2011.

To be sure, while we fully commiserate with those hedge fund managers who will scream in abject terror that hedge funds are not meant to beat the S&P, our response to them, in kind, will be "good luck convincing your LPs, whose redemption requests have already been filed" that paying 20% upside to a manager is worth it when you have the world's central banks acting as Chief Risk Officers for the entire stock market and collecting nothing in exchange (well, except trillions of dollars in public debt and deferred hyperinflation).

And convincing they will need, because as Bloomberg reports, "the outlook for hedge funds, already closing at the fastest pace since the financial crisis, is about to worsen, according to Citigroup Inc."

After many years of getting the benefit of the doubt, LPs and investors in hedge funds have finally had it and with industrywide profits 2014 sliding 30% from a year earlier to $21.9 billion because of poor performance, Citigroup is certainly not beefing up its Prime Broker business.

What is happening as a result in the hedge funds space is the same as that seen in the corporate arena: the big are getting bigger, capitalizing on whatever pseudo-monopolistic economies of scale they have, while the small are chewed, spat out, and promptly forgotten:

Average hedge fund returns have shrunk as the industry has exploded in size to $2.8 trillion from $973 billion in 2004. The industry has shifted as investors gravitate to larger, more established managers. Some banks, including Bank of America Corp., are also cutting prime brokerage ties or increasing fees for hedge funds that don’t meet profitability targets.

Weak returns combined with record-high industry assets mean that management fees now account for a bigger share of total profit than revenue from performance fees in years when returns slump, according to the report. Last year it was almost 2.5 times greater, Citigroup said.

Other observations by Citi:

Last year’s performance resulted in only a 7 percent drop in the theoretical equity value of the industry, which fell to $239 billion, according to Citigroup. The calculation estimates the amount of capital that would be raised from selling off equity shares in the hedge fund firms.

 

The value fell at a lesser rate than profits because proceeds from management fees are weighted more highly than those from incentive fees, which tend to be less stable, when valuing of firms.

 

Hedge funds’ $31.2 billion in 2013 profits accounted for 34 percent of the $93 billion in total asset management industry revenue, according to the report.

 

The bank’s survey was based on responses from 149 firms with $581 billion, or about 20 percent of industry assets.

The best performing hedge fund of 2014 is well-known: "Bill Ackman, the billionaire investor who wages campaigns against corporate management and boards, made more money for his clients than any of his rivals, according to a Jan. 26 report by LCH Investments. Hedge fund managers netted $71 billion for investors last year, with the top 20 accounting for $25.2 billion, London-based LCH said."

And all he had to do was to collude with Valeant - a strategic - over the failed acquisition attempt of Allergan, while purchasing a massive amount of call options, i.e., leverage, and cashing out when Allergan went in play. So far, the SEC's take is that this clear form of insider collusion and trading is legal. One can hope this view will be reversed, but one should probably not hold their breath.

So for all those smaller hedge funds, who didn't quite have the scale nor the clout to pre-plan what is allegedly an illegal transaction, pre-blessed by captured former SEC lawyers, what will the future bring?

Poor performance will be most acutely felt by small hedge fund firms,” Sandy Kaul, global head of business advisory services at the New York-based company, said in the report, referring to those with an average of $100 million in assets. “These funds simply did not generate enough performance-fee revenues in 2014 to cover their gap.”

In other words, "small" hedge funds, those who tried valiantly for 1, 2 or more years to generate alpha, and failed, well they can continue to manage "small" amounts of money, however it will be of the paper variety. Which they are welcome to do on the one venue which has taken over for Yahoo Finance as the sole place where everyone pretends to not only trade but certainly never have even a single losing day: Twitter.