A growing stream of thinking in microeconomics is the concept of "winner-take-all" dynamics. The idea seems simple. A combination of networking economics and classic economies of scale creates situations where there are just a few dominant firms or economic agents who are able to capture significant market share in a given industry. With the advances in technology over the last decade, many industries are seeing the impact of winner-take-all dynamics leading to the result of greater concentration.
There have always been economies of scale with a firm, but there were limits based on geography, distribution, or just the ability to gain broad exposure. However, with the internet and the ability to communicate information broadly and quickly, the power of networking generates further economies of scale.
There are some classic winner-take-all markets. For example, the music industry is dominated by a few singers who capture all of the market. Software, search engines, operating systems, or social media have all become winner-take-all markets. The first mover or close followers are able to gain strong market positions that cannot be broken by new entrants.
We may now be seeing the beginning of winner-take-all dynamics with hedge fund investing. The combination of scale for investing with wide distribution has caused large hedge funds to get larger and more dominant regardless of performance. Think of winner-take-all networking and scale and you can see the how size matters more with hedge funds. We are moving from a highly competitive fragmented industry to one that is more concentrated. This will not happen overnight, but the signs of growing concentration are starting to be seen. Start-ups are slowing and smaller funds are closing.
Size allows for:
- Economies of scale for passing due diligence - Passing due diligence for large investors requires more infrastructure from independent due diligence to redundant systems and independent trading. To gain money from large pensions, more scale is needed.
- Economies of scale with compliance - Regulation requires more compliance which is a large fixed cost. Scale spreads this fixed cost.
- Broader distribution - The costs of marketing are high. This is not just visiting investors but providing investor relations and answering questionnaires.
- Platform access - More hedge funds need to be on platforms which have barriers to entry. Additionally, prime brokers want to only deal with larger firms.
- Multiple products - Given the cost with reviewing firms, there is a desire for more products from the same firm. One stop shopping is gaining acceptance.
- Matching with large investors - Concentration in banking and brokerage means that large firms will deal with other large firms.
Is this good for investors? Scale will allow for the lowering of costs and allow for better infrastructure development. These lower costs can be passed onto investors. The better infrastructure developments in compliance, risk management, transparency, and investor relations all reduce business risk and provide benefits to investors, but the larger firms may not always perform better. Performance is just one aspect with the decision to invest. Now small have to perform better with excess returns to offset the higher business risks.
The idea that a smart manager can open a shop and attract investors to their new business may be ending. Performance as the key driver for new entrants may be ending.