Covid-19 vs Hedge Funds

‘Quarantine’ – derived from the Italian words quaranta giorni (forty days)

So here we all are, bunkered down in isolation, protecting ourselves and our loved ones from Covid-19, and more than likely working from home, or as our business continuity plan states, ‘remote’ working.  My thoughts have turned to how will we emerge into this ‘new’ new-world order, and more specifically, what does this mean for the hedge fund industry?

The Great Plague

The financial system has not faced an event of this magnitude since the last great global pandemic: The Great Plague of the 17th century. In England, this was the last gasp of the bubonic plague, a disease that had cursed the world for over 400 years. The severity of the situation is highlighted by the fact that between 1665 and 1666 the plague killed over a quarter of London’s population. Like today’s Corona Virus, this outbreak saw borders shut and the closure of many businesses and schools.

At a macro level we have the worst market decline recorded, a contracting global economy, unemployment at its highest level in a generation, central banks pulling never before seen levers and an ever-increasing authoritarian governance. At a societal level the impact on many families is tragic. The devastation meted on the traditional economy is yet to be fully realized, but many factories, restaurants and shops will not reopen once the quarantine is lifted. Looking in from the outside the situation dire.

Hedge funds are in no way immune to this turmoil and could be said to be sitting in the eye of the storm. The toll of the market decline cannot be underestimated. The scale and ferocity have left many investment managers nursing losses that, for some, will discredit their strategies and reputations resulting in, at best, a severe decline in assets, and at worst, closure.

Even those managers that have delivered in these markets will not come away from this untouched. The investor community will be seeking liquidity, and hedge funds are vulnerable to this scramble for cash, thus leaving these success stories frustratingly in a similar position to those who were on the wrong side of the market.

Furthermore, those management firms which had seized the opportunity to build out their businesses during the nine-year bull market will be re-assessing their business models. Many a long hour will be spent poring over previously concocted plans resulting in tough decisions based on an uncertain future.

Survival of the Fittest

In my experience, the hedge fund industry is one of the most efficient demonstrations of   Darwinian Theory. Much like the emergence from the Great Recession of 2007-2009, we can expect the larger firms to not only survive but continue to expand. However, in this new new-world, size will not be the only factor to survival, as there will be a need to also adapt. As the industry behemoths have grown, they have sacrificed nimbleness. These firm’s ability to react efficiently will have been diminished and decisions will be made to trim the fat, but I expect the knife will dig deeper into the healthy meat.

The hedge fund industry remains, in the most part, boutique investment management firms. These small enterprises, with typically less than 25 employees, have the perfect form to adapt to the new environment efficiently. Many will not survive, though that in itself is not unusual even in a normal market, but those that do will need to reflect on their current business models. Firms who see their assets decline by thirty to forty percent will be looking into their costs and trying to understand what can be done to reduce spending while maintaining a viable business model. Fixed costs will be their Achilles heel!

A Time for Reflection

“To every action there is always opposed an equal reaction.” – Sir Isaac Newton

The barriers to entry for new managers have never been higher but neither has there been an opportunity of this magnitude. Between those managers being cast out with the bath water, the new talent coming through and veteran managers returning, the future looks bright for the next generation of hedge funders.

It was in 1665 that Isaac Newton, a rather underwhelming student at Trinity College Oxford, was sent back to his family home to continue his studies in isolation following the closure of schools as a precaution against the Great Plague. Upon his return to Oxford in 1667 he presented his theoretical developments in calculus, and optics, but more famously, the law of gravitation.

Like Isaac Newton, I anticipate this ‘next-gen’ of managers will be open to alternative thinking. The lessons, and reflection, drawn during this period of quarantine will impact their modus operandi, work-life balance and community participation.

It will make sense to stay lean and agile, let’s not forget, these next-gen’s have experienced the Great Recession, longest bull market on record and now Covid-19 just in the last 10 years. They are well adapted to living, working and profiting in tumultuous times.

The impact of Covid-19, and our reaction to it, will be far reaching into our future. It is impossible to predict the future, but it is at these times that humans demonstrate why they are top of the food chain. Our ability to adapt is awe inspiring. It is not without cost that we will move forward, but we will, and with it I anticipate will be a better understanding of who we are and the world around us. Likewise, the hedge fund industry will adapt and move forward and, I expect, will be better for it.

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Quay Partners Group delivers bespoke investment management solutions to independent hedge fund managers and family offices.

Thomas Underwood, the Founder, has over 20 years experience in managing and operating hedge funds.