Hedge Fund Blues

Barrons\' Hedge Funds

The hedge fund industry is coming under close scrutiny for a variety of reasons. In fact, it seems like that bad news doesn’t stop.

– Madoff runs a giant Ponzi scheme that claims up to $50 billion in losses. The exact amounts will be different because some of the “losses” represent paper profits on statements that he sent to customers that were phantom but assuredly they are large and painful
– Worse than this scheme was the fact that so many “fund of funds” or hedge funds that are comprised of investments in other hedge funds charged a big fee for the right to invest in this fund in the first place. Gulp
– Many funds that claimed they were “hedged” against market moves (where the “hedge” in hedge funds comes from) most assuredly were not; large losses of 40% or more are common in the listings, and some very big names have been seriously bruised

More subtle than these obvious issues are the fact that these hedge funds often have “high water” provisions. Funds typically make money by charging an annual fee of 2% a year and 20% of profits. However, if the fund declines in value, the hedge fund can’t charge the 20% fee on profits until after the old “high water” mark in value is reached. Thus if your fund was down 25% this year, you have to gain 33% before you can start earning your 20% cut again. On top of the “high water” issue, if your asset base drops 40% (remember those losses, above) then you are only making 2% on 60% of your former assets.

Another element is that banks aren’t going to lend as often or as frequently to hedge funds. Much of the gains that hedge funds claimed to make above the market are due to leverage. For example, if you put $1M in the stock market, and it goes up 20%, you have $1.2M. On the other hand, if you put $1M in the stock market, and borrow another $1M (at a low interest rate like 5% which the hedge funds probably used to get), then your $1M has a gain of $400k less the 5% interest which is a total of $350k. Thus your investment went up 35%, not 20%, due to the advantage of leverage. Some academics say that the entire hedge fund “premium” (or “alpha”, as they call it) is due to leverage and you or your endowment could accomplish the same thing with debt all by yourself (without the 20% cut of profits).

With the “high water mark” issues, the fact that 2% of assets doesn’t go far when your asset base has declined 40% due to losses, and the fact that banks and other entities aren’t loaning out cash cheap to hedge funds anymore, the whole industry is facing a bleak future. Some commenters are expecting 1/2 the total hedge funds out there today to fold.

I was struck when I read today’s Barrons’ and you could see the performance statistics and strategies for pages and pages of individual hedge funds in tiny type. The hedge funds used to highly value their privacy (some, like Madoff, for obvious reasons) and this clearly isn’t the case anymore.

One argument in favor of the 20% “cut” of profits (I don’t begrudge them the asset fee) is that their strategies were proprietary and hard to pull off. But when I look at these pages and pages of hedge funds, often with very similar performance under each strategy (and most of the strategies relatively understandable), I don’t see that at all. Obviously it can’t be so hard to do strategy “X” because there are many other funds doing the same thing, getting roughly the same results.

These strategies could likely be pulled off, if they were desired, by in-house staff at large institutions or endowments or within large brokerages like Fidelity or Schwab with a much lower premium than 20%. Then individual investors could purchase shares in those if they desired to participate in the strategies.

Watch for the final indiginity; lots of these hedge funds will close up shop because they don’t want to work for years without their 20% cut trying to recapture the investor losses, and then they will spring back to life with a clean slate and start earning the 20% on NEW investor money. Maybe the investors will demand tougher conditions (10% of profits) or actual “claw back” provisions where they can pull back money earned from the fund if losses occur later. Or maybe they will hire a few of their people and do it themselves, probably for closer to the 2% management fee than the 2% plus 20% model.

Cross posted at LITGM

7 thoughts on “Hedge Fund Blues”

  1. I’ve always considered hedge funds to be the most ridiculous sort of pseudo-investing. Investment always comes with the risk of losing money, to pretend otherwise is mere silliness. At least now these funds seem to be operating as a form of taxation on those with a too high wealth to common sense ratio.

  2. -The term “hedge fund” doesn’t define investment strategy. It’s a term of convenience used to characterize investment funds that don’t fit in with stock mutual funds or other regulated fund categories. Hedge funds don’t necessarily hedge and no one expects them to. The expectation of any sophisticated investor is that a hedge fund takes risk in a market or trading-strategy sector where the fund managers have (or believe they have) an edge.

    -Hedge funds cater to “sophisticated investors,” which in practice means people with money and investment experience, or at least money and the willingness to sign risk-disclosure forms. The statement about fools and their money might originally have been directed at investors who sign risk-disclosure forms without understanding them or without taking them at face value.

    -On the 2/20% management/incentive fee deal, I would argue that with high-risk investments high incentive fees are good because they align the manager’s incentives with those of the customer. Management fees may actually work against the customer’s interest, because they give fund managers an incentive to raise the largest possible pool of investment funds, independent of fund performance. Raising a large amount of money is not incompatible with generating high returns on that money, but it does make generating high returns more difficult, and at the extreme a corrupt manager can work for management fees alone at the expense of his clients’ investment expectations. Consider also that leverage increases management fees, e.g., at 2:1 leverage a 2% fee becomes an annual 4% of actual cash invested, which is steep unless risk-adjusted performance is exceptionally good. For these reasons there are highly-regarded and profitable investment funds that work on a pure incentive basis, e.g., 25% of new net profits and no management fee.

    -High incentive fees are needed to attract high-performing fund managers. The best managers tend to have proprietary trading methodologies that are worth 20% of net profits to investors. Otherwise the market couldn’t sustain such high fees. A bank can’t duplicate such systems in-house because banks won’t pay enough. Someone who is capable of generating a 15+ percent compounded annual return is not likely to be willing to work for a bank salary + bonus when he can make millions on his own.

    -Clawback provisions and other restrictions on managers sound great as marketing ploys, but at some point it becomes difficult to hire managers. In general, investors who want to retain the possibility of making exceptionally high returns are going to have to pay for that privilege, and that means taking substantial risk or paying managers a high percentage of profits or both.

  3. Certainly I was simplifying in the article and you pointed out some key items.

    In general, many of the hedge fund strategies aren’t that hard to replicate – just check the pages and pages of hedge fund results, neatly categorized into their respective strategies, with performance that is often similiar. While these strategies range from the super-complex to the not-so-complex, much of them could be pulled off with in-house personnel.

    It is the FUTURE market beating strategies that I won’t be able to see, and those would be worth paying a high premium for, if they could be found.

    The one item I disagree with is the 20% of profits essentially for doing their job. Many other fields require dedication and creativity and hard work without paying out billions just because the market rises as a whole and easy money is here now.

    Probably a “split the difference” plan would be to index performance to a benchmark, say the S&P 500 (juiced up with appropriate amounts of leverage as used by the fund, so that easy trick is out of the way), and give them 20% of the profits for beating THAT benchmark. That is the type of performance that people should pay big bucks for, not the pedestrian performance that I saw in the Barrons’ records.

    Also, attracting talent is a relative term… there is no where for them to go now. The investment banks are essentially dead, hedge funds are on a massive retreat, and private equity is moribund (more to come on that).

    Unless you 1) bring your own capital to the table 2) can bona-fide beat the market – the easy $ are gone. Perhaps the gov’t money will bring 1) back to life.

  4. Incentive fees at around 20% have been around for years. Some firms charge more. Split-the-difference deals and middleman cuts are common. Yet the 20% base rate is still around, which I think implies that it’s justified. Firms for which it’s not justified will go out of business, but that’s business. There are always booms and busts and industry shakeouts. The managers who perform well by not losing a lot of money during the busts deserve their 20% when times are good and I suspect will continue to get it.

    Or to put it another way, customers already index performance to benchmarks, but they do it informally, by pulling their investments from nonperforming managers.

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