When most people think about math, they don’t necessarily think about visual aids. They think about numbers. They think about symbols. They may even think, “Oh crap, I hated math in high school.” Even if you are in the last camp, read on. I promise what follows is painless, although you may be tested on it later.
A lot of times, what’s problematic for people about math is that picturing and therefore connecting with what we’re talking about, particularly when dealing with large numbers, can be difficult. For example, I talk endlessly about the inequities in the hedge fund industry, and yet while some folks hear it, I’m not sure how many people “get it.” So today, we’re going to “connect the dots” to visualize what is going on in hedge fund land.
First, meet The Dot Fund, LLC.
This dot represents a single, average hedge fund. The fund probably has a pitch book that states its competitive advantage is its "fundamental bottoms up research." This makes me want to shake the Dot Fund. But I digress.
Now, most folks estimate that the hedge fund universe contains 10,000 funds, so here are 10,000 dots. Each smaller square is 10 dots by 10 dots, for a total of 100 dots, and there are 10 rows of 10 squares. Y’all can count them if you want to – I did and gave myself a wicked migraine – but this giant square of dots is pretty representative of the total size of the hedge fund universe.
The Hedge Fund Universe
Of course, the hedge fund universe isn’t as homogenous as my rows of dots, so let’s look at some of the sub-categories of funds. The blue dots below represent the “Billion Dollar Club” hedge funds within the universe. That is not a ton of dots.
The Billion Dollar Club Hedge Funds
And here are the Emerging Managers, as defined by many pension and institutional investors as having less than $1 billion in assets under management. Note: That’s a helluva lot of blue dots.
Institutionally Defined “Emerging Managers”
This is the universe of managers with less than $100 million under management, or what I would call the “honestly emerging managers.”
Managers With Less Than $100m AUM
This dot matrix represents the average number of hedge funds that close in any given year. It doesn’t look quite as dire as the numbers do in print...
Annual Hedge Fund Closures
Finally, here are the women (stereotypically in pink) and minority owned (in blue) funds that I estimate exist today.
Diversity Hedge Funds
While estimates of capital inflows vary, eVestment suggests roughly $80 billion in asset flows for 2014, while HFR posits $88 billion. Because the numbers are fairly close, I'm using HFR, but the visual wouldn't be vastly different if I used another vendor's estimate. Here is the HFR estimate of $88 billion in asset flows represented as 1 dot per $1 billion.
2014 Estimated Asset Flows into Hedge Funds
Now, here is the rough amount of those assets (in blue) that went to the Billion Dollar Club hedge funds (also in blue).
Fund Flows Into Large Hedge Funds
And here is the rough proportion of those assets that went to everyone else.
Fund Flows Into Emerging Hedge Funds
Not a pretty picture, eh?
So, what’s the point of my dotty post? While I think we all have read about the bifurcation of the hedge fund industry into assets under management “haves” and “haves nots,” I’m not sure everyone has actually grasped what’s going on. I’m told that a picture is worth a 1,000 words, so maybe this will help it sink in. Not investing in a more diverse group of managers creates a very real risk of stifling innovation and compromising overall industry and individual returns. It also creates a lot of concentration risk - if a Billion Dollar Club fund fails, a large number of investors and a huge amount of assets could be at risk.
And the kick in the pants? We know this pattern isn't the most profitable. A recent study showed pension consultants underperformed all investment options by an average of 1.12% per year from 1999-2011, due largely to focusing on the largest funds and other "soft factors." And lest you think 1.12% sounds small, let me illustrate that for you, too. Here are one million dots, where each dot represents a dollar invested. The blue dots are the cash returns over time that were missed by not taking a more differentiated approach. Ouch.
Cash Return Differential 1999-2011
Luckily, the cure is simple. Commit to connecting with different and more diverse dots in 2014.
Sources: HFR, eVestment, MJ Alts, Value Walk, "Picking Winners? Investment Consultants' Recommendations of Fund Managers" by Jenkinson, Jones (no relation) and Martinez.