Hedge fund performance centers on alpha generation. Alpha can come in many forms, but one that is clearly dominating the attention of many firms is cost containment. The drive to cost containment is based on two key components. One, there is relentless pressure from institutional investors to cut fees. With fees always pushing downward, firms have to become more efficient. Second, as hedge funds increase their trading volume, transaction costs become an increasingly important area for potential value creation.
By cutting down the cost of trading, there is an immediate gain in return that flows through to the bottom line, reducing performance and incentive fees. Lowering the bid-ask spread improves returns. Executing with less slippage again enhances performance. The gain from cost containment is generally immediate and does not have to wait until ideas embedded in trades generate returns.
Cost containment is especially valuable to firms that are gaining scale. There can be specialized trading desks, centralized research, and risk management that can use economies of scale. All provide an edge that will squeeze out smaller firms that cannot gain economies of scale.
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