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The former reality of frequent hedge fund launches is no more, with tighter fee margins and higher costs weighing down the industry. While, according to a recent article by the Economist, billion dollar hedge fund launches typically were viewed as commonplace in the past, current new offerings are generally much smaller and less frequent, causing serious implications for the industry and those seeking hedge fund jobs.

Smaller funds also tend suffer from reduced economies of scale. The article suggest that at a two percent fee rate, a $100 million hedge fund can expect to earn $2 million in a year, leaving little remaining after paying required salaries and bonuses. Larger funds can benefit from economies of scale as many compliance, accounting and legal costs tend to be fixed, rather than variable in comparison to assets under management.

Increased Compliance Costs Continue to Weigh on Hedge Funds

These increased compliance costs are a major factor weighing on the industry. The Economist article blames the Madoff scandal for the increased regulatory burden, but in fact, the reality goes much deeper. The overall financial industry is facing increasing compliance and regulatory costs as a result of public concerns over accountability following the financial crisis. Unfortunately for hedge funds, as some of the smallest players within the industry, the burden falls more harshly on organizations without considerable scale.

Fewer Financial Professionals are Leaving Big Institutions

In the wake of the financial crisis, restrictions on banks trading their own accounts increased. This resulted in many star traders being forced out of their positions at large institutions, with many deciding to start up new funds. This flow of financial professionals has slowed considerably now that the industry has largely completed that shakedown, which may contribute to the reduction in the number of new hedge fund ventures. A long track record of trading success is required in order to stake it out by oneself in the financial industry, and simply put, these individuals either have remained retained by their big firms or have already started their own hedge funds or wealth management practices.

What are the Implications for Hedge Fund Job Seekers?

The news of declining hedge fund launches on the surface seems like a negative trend for those seeking opportunities within the industry. With fewer players, it seems as though fewer opportunities would exist. In some cases, this may be true, but it doesn’t paint the entire picture. While there may be fewer players, the overall assets under management in the industry have largely remained intact, meaning many of the jobs that would have been required to manage funds in new firms are simply managing the funds in larger firms. The relationship may not be one to one due to those economies of scale, but the situation is certainly not as bleak as it may appear at first glance. Larger firms may also offer opportunities to lesser experienced individuals, whereas small shops require all team members to have a great depth and breadth of knowledge and experience.

Further, those increasing compliance costs generally reflect the salaries of skilled financial professionals hired into compliance-oriented roles, which represents a fast growing source of opportunities throughout the financial world. While on the surface the news of declining hedge fund launches may not seem positive, there are numerous opportunities if job seekers look beyond new start-ups.

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The first three quarters of 2012 have been rather weak for the hedge fund industry, posting returns of 3.04 percent, when compared to the relative strength of the S&P 500 index, which returned 13.97 percent over the same period. Mary Ann Bartels, an analyst with Bank of America Merrill Lynch, told the Financial Post that these struggles represent the third worst relative performance for this period since records began in 1994.

Several strategies have been negatively impacted by current economic and market conditions. Market neutral strategies are off more than 5 percent for example, while top performing strategies such as convertible arbitrage are still trailing S&P 500 returns. Hedge fund returns are not always expected to beat equities, but it is a perception benchmark that most managers grow concerned with when successive quarters indicate lagging results.

While recent results have been less than desirable, according to Bartels, hedge fund returns have outperformed the S&P 500 by 130 percent between the end of 1994 and August 2012. The funds have also performed better on a risk adjusted basis. Most investors in hedge funds are not seeking to beat equity indexes every year either, but rather they take a long term view where consistent returns are preferred to the up and downs of traditional investments.

Risk Taking Climbs to Combat Low Returns

While alternative asset classes are intended to represent returns that are not linked to equity indexes, often portfolio managers have to answer to clients demanding why they haven’t earned as much as their colleague who is invested in high risk equities. As a result, hedge funds feel pressure during bull markets to increase risk taking to attempt to match the returns being seen on global equity indexes (defeating some of the original investment objectives of some investors). And it seems that this pressure has increased to the point where managers are employing riskier strategies to increase their hedge fund returns.

The Wall Street Journal has recently reported that risk taking has increased substantially in the hedge fund industry this year. The article suggests that while sophisticated institutional investors remain largely focused on low volatility plays, there is a segment of the industry returning to its “roots” in higher risk, higher return trading strategies. Most of these players operate within fund-of-funds models, where high drawdowns or losses in one fund won’t severally impact ultimate owners as it should be offset through diversification. These small funds are attempting to justify the higher fees being charged by hedge funds in comparison to general equity funds by employing high return strategies. Otherwise, investors are struggling paying the substantial fees just for beta that could be cheaply achieved by indexing through equity or inverse equity strategies.

Hedge fund managers and investors need to remain vigilant against excess risk taking, however, as regulatory reform always looms as potential punishment for a trade that has always lived on the edge. The shift back towards risker strategies certainly puts the entire industry at risk, especially in a political environment that is far less tolerate of market principles then many in the business are used to.

What Does this Mean for Job Seekers?

The hedge fund industry has always been one marked by rapid change, shifting to the strategy of the day in light of current market conditions. The weak results seen currently by most strategies may result in the allocation of money to asset classes such as private equity or real estate, as alternatives to hedge funds. This would certainly be a net negative for job seekers, as hedge funds would need to pare staff to control costs if assets under management decline.

On the flip side, however, the increased appetite for small and nimble funds, executing complex or risky strategies, plays well to those with entrepreneurial spirit in the industry. There is certainly an increase opportunity to launch a new fund with a specialized trading strategy in these market conditions, or join a newly launched firm in a support role.

With that considered, the hedge fund industry overall remains an opportunists market when it comes to job opportunities. Applying specific skill sets or experience, and utilizing industry connections will be the primary way into the market. With the abundance of financial professionals seeking work, individuals must react quickly to available opportunities and actively engage their networks.

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