During a Q&A session at Grant’s Interest Rate Observer Conference this week, hedge fund billionaire Leon Cooperman took the microphone and shared an observation about the investment business with the room.
“Not much of a question but really I want to share something with you,” Cooperman, 73, prefaced. “About eight months ago I went to a seminar that had nothing to do with he stock market. The seminar was entitled ‘Closing the Gap,'” .
He continued: “It had all to do with income disparity and how to deal with it. And there was a futurist who spoke at the conference.”
According to Cooperman, the futurist was “very provocative” and said the biggest problem the economy faces in the next decade is automation.
“He said the biggest problem in his opinion the economy was facing in the next decade was 45% of all jobs being performed in the economy will be replaced by automation. And there’s no alternative employment for displaced workers.”
Cooperman pondered what the futurist said, and he identified a parallel between the impact of automation on jobs and passive investing on the hedge fund industry.
“When I went home that night I reflected on it and I thought maybe the automation impact on our business is really indexation,” he said. “At the end of the day, hedge funds exist —and I’m one of them — because you’re supposed to outperform. You can’t get a premium fee unless you outperform, right? If you don’t outperform you’ll basically lose your assets.”
The hedge fund industry has been under intense scrutiny for a variety of reasons. For investors, the biggest issue has been underperformance relative to low cost alternatives like index investing.
Cooperman believes indexation will have two big consequences for Wall Street. First, liquidity in the market will diminish because there’s less trading and there will be fewer commission dollars to support broker-dealers that provide that liquidity.
“Passive [investments] average about 3% [turnover] a year and active turnover averages about 30% a year,” he said. “So there’s an enormous reduction in commission pool available to suppliers, the brokers, and reduced liquidity in the market.”
The second consequence will be on the money management side in the form of tremendous downward pressure on fees. Typically, hedge fund managers who use active strategies are paid through a compensation structure commonly known as the “2 and 20,” which means they charge investors 2% of total assets under management and 20% of any profits.
Meanwhile, fund managers employing passive, index-type strategies will charge just a fraction of 1%.
“You can probably get an index fund for I guess what? 20 basis points, something like that? And if you’re basically a large pension fund, you get an index return of 5 basis points. So there’s going to be an enormous reduction in the fees in the industry.”
He concluded: “As I thought about it, the only thing that’s really going to change it is we’ll need a bear market.”
Cooperman, who has been running Omega for 25 years, was civilly charged with insider trading by the Securities and Exchange Commission late last month. In a letter to investors, Cooperman denied the agency’s allegations and maintained they have done nothing improper.
Julia La Roche is a finance reporter at Yahoo Finance.