Hedge Funds: Two-and-Twenty

The list of top ten hedge-fund earners for 2006 includes three people who I guess to be turnaround specialists and "industrial statesmen"--management entrepreneurs building or fixing organizations a la Andy Carnegie or Johnny Rockefeller or Charlie Coster of a century ago--Icahn of Icahn, Lampert of Sears, and Tepper of Appaloosa. It includes three people who I guess to be primarily wholesale bankers--Griffin of Citadel, Jones of Tudor, and Kovner of Caxton--making money through financial intermediation: taking on relatively long-term or securitized risk and hoping to God their information about the true value of those risks is better than the market's and that they are properly diversified. It includes two people who I guess to be primarily speculators--one high-tech and quantitative, Simons, and one lower-tech and judgment-based, Soros. And it includes two people--Cohen of SAC and Barakett of Atticus--about whom I am basically clueless about what they are doing.

Their high fees may be best conceptualized as a gap between book and market value: if they were publicly-traded corporations, you would have to buy into the stock of their organizations at a premium to book value. The hedge fund form, however, allows you to buy in at book value--minus fees. And the premium between book and market is then captured not (as it is in a public corporation) by all the previous equity investors, but just by the first initial tier.

Why this particular hedge-fund form of organization has risen to the top of the barrel right now is an interesting question. But it is clear that at the top we have people and organizations either with real skills and real edges operating at the financial economy's pressure points and adding mammoth long-run organizational and intermediational value--or people taking on huge adverse tail risks in hard-to-assess ways who have so far been lucky. It's hard to tell the difference.

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

Suddenly, Hedge Fund Fees Seem High: Steve Rosenbush: The top-performing hedge funds and private equity firms have generated annual returns in excess of 50% during the last few years.... Now some institutional investors have started to complain, noting that the average hedge fund failed to keep pace with the market in 2006.... CalPERS Chief Investment Officer Russell Read said many hedge funds charge too much without delivering high enough returns or low enough risk. "We have no problem paying high-performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," Read told attendees at the Geneva conference.... A hedge fund typically charges investors a management fee of 1.5% to 2%, and takes 15% to 20% of profits the fund generates. An index fund's management fee, by contrast, is typically just hundredths of 1%. The prominent Vanguard 500 Index Fund (VFINX) has an expense ratio of just 0.18%, for example....

[I]n 2006... CalPERS... $4.3 billion in hedge fund investments generated a return of 13.4% for the year. That was slightly ahead of the average hedge fund return of 13%, but just below the 13.6% return the Standard & Poor's 500-stock index generated in 2006....

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

Investment banks such as Goldman Sachs (GS), Merrill Lynch (MER), and Morgan Stanley (MS) have introduced lower-priced investment vehicles that may compete for some hedge fund business. Goldman, for example, introduced a product in Europe last fall called the Absolute Return Tracker... "expected to display returns over time that resemble some of the patterns of hedge funds as a broad asset class."... [S]ome private equity shops are trimming fees as a response to the sheer size of many new funds. The Blackstone Group, which is in the process of issuing about $4 billion worth of stock in its management company to the public, charges a management fee closer to 1%, industry experts say...

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.

Comments

[don majors]

"the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services"

It is a testament to "proof" by repeated assertion and advertising that you get what you pay for. There is no logical reason to accept these assertions. It's just that anything that exists unchallenged becomes the acceptable norm. It may not make sense. It may be unreasonable. But,it remains a credo of the masses in dealings in real estate, political representation, and law. John Bogle fought and continues to bring out the simple facts in his new "little" book. Hurray for John Bogle.

[knzn]

Most hedge funds are supposed to be low-beta. To the extent that their risk is truly idiosyncratic, it’s worth paying 2-and-20 even for lackluster returns, because they don’t add any risk to a portfolio. The ideal hedge fund, with a positive (but not necessarily large) expected return that is uncorrelated with any asset class (including other hedge funds) is theoretically worth paying a lot more for. The difficulty is in determining whether the true correlations are really so low.

[bernard Yomtov]

It may have angered Bogle, but it hardly drove him insane. He seems quite rational to me.

[Douglas Knight]

knzn,
Maybe it's a reasonable price to pay, but it's pretty clear that everyone interprets the 20% as an incentive for high returns. Moreover, how big is the market of people who understand beta?

[chris]

Bogle's still going hard at 'em:

http://www.johncbogle.com/wordpress/

[DC Tax Wonk]

knzn & Douglas:

It's worth bearing in mind that the "20" is 20% of net positive returns in a year, not of assets -- and moreover, its my understanding that there's typically a "hurdle" in the neighborhood of an 8% return before the manager gets to start collecting this 20% (i.e., the first 8% of return in a year is preferentially allocated to the investors, after which the manager starts to get its 20% "carried interest," often with a "catch-up" disproportionately allocating the manager greater than 20% over a range until they've gotten 20% of returns back to dollar-one, and everything above that gets a straight 80/20 split).

As a result, the manager of a hedge fund earning mediocre returns is not getting "2 and 20," but only the "2" (i.e., 2% of assets-under-management -- which might, theoretically, be worth the price if the hedge fund is in fact poorly correlated to the rest of the market, as knzn suggests).

[archer]

Let's get real here. The "not correlated with the market" arguments above as a justification for the 2% fee is what in the hedge fund trade is called "alternative beta". In other words, you aren't just getting alpha, you are also getting a useful risk profile.

Problem is that it's largely bunk. If you merely want alternative or synthetic beta, you can construct it much more cheaply, on your own (or now via hedge fund clone services sold by the likes of Goldman and Merrill). And a recent conferecence, Merrill got stony silence by announcing that its analyses of the industry showed that hedge funds were generating no alpha. Ouch.

For typical portfolios (stocks, bonds, cash), academic studies have found commodities to be a much better addition than (non-commodities) hedge funds. Securities have negative skewness, while commodities have positive skewness.

So why do people (and institions) pay those crazy fees? Same reason people used to buy IBM. No one will criticize you if you buy a legitimate hedge fund, and you are considered to be doing a disservice to your investors if you don't have some exposure to alternative investments (private equity, hedge funds).

There was a great Brookings paper written in the early 1980s by Vishny, Lakonishok and Shleiffer which I have been unable to locate on line. They looked at the money management industry and were completely mystified. They concluded it added no value and wondered why it persisted.

The same mystery exists and has been extended by hedge funds. Mere mortals don't have the time and energy to manage their money. It makes them feel better to hire a pro. And a few have been able to earn better returns with some consistency (or is it simply that they are lucky?) and people are willing to pay a huge premium for people like that. The real question is why the wanna bes can command the same fees.

[Percy Walker]

DC Tax Wonk -- The hurdle and catch-up you describe is typical of private equity funds, not hedge funds.

[Jim Van Fleet]

Cohen is in the camp you put Simons in, although the secrecy that he keeps obviously gives him some freedom.

[sd]

The only point I'd add to the discussion is that it is very very dangerous to try to draw insights into the workings of the alternative asset investment industry (hedge funds, private equity, etc.) by looking at the traditional money management industry (equity mutual funds and pension funds, bond funds, etc.).

It is tempting to say "Hey, 30 years ago everyone assumed that the smartest mututal fund managers could beat the market so they paid them steep fees to actively manage their money. We've since learned that active management offers no value-add net of risk, so you should just buy low cost index funds instead. Its the same way with these hedge funds, who collectively can't be adding value."

It is, however wrong to say this. Or at the very least, its an open question.

Active management doesn't add value in the mutual fund and pension fund industries because those industries are mostly characterized by the following conditions:

* The assets traded (shares in public companies) are highly liquid, actively scrutinized by a large number of smart investors, and subject to extensive disclosure requirements
* The portfolios of these investment funds are by convention and law highly diversified, meaning that any given equity position is very small, meaning that the ratio of transaction costs to equity value in these positions is quite high
* The strategies employed by these investment funds are by convention and law limited to simple buy and sell moves

Now contrast this with alternative asset classes:

* The assets traded (ownership of private companies, large stakes in public companies, exotic derivative positions, etc.) are mostly illiquid, scrutinized by only a handful of smart investors, and often not subject to disclosure at all
* The portfolios of these funds are sometimes highly concentrated in a few big bets, meaning the ratio of transaction costs to equity value in each position is quite low
* The strategies employed by these funds are limited only by the creativity of the fund managers

Now given this, it is quite plausible that the best alternative asset managers can indeed add significant value net of fees and risks, and thus can in a free market rationally earn exceptional compensation.

It may well be the case that various alternative asset classes as a whole do not outperform the S&P on a fee and risk adjusted basis, but so what? The question is whether the upper echelons do. In the case of traditional mutual funds, a large body of research over time said "No - the 'best' mutual fund managers are just lucky." But in the case of alternative asset classes there is no definitive answer on the performance of the so-called "best" funds. It should be pointed out though that the limited partners of Texas Pacific Group, Citidel, etc. have been very - very - happy for a very - very - long time now.

[Caravaggio]

The story of the Emperor's clothing comes to mind when we look below the very top performing hedge funds. Myself, I know of one small group of money managers whose only concern is the 2, not the 20. A few years of managing a fair sized chunk of funds will provide them with a hefty payout. Like many others, they are employing a long-short strategy, but even they don't believe it has much of an edge.

There must be many small firms out there operating with such a view, and it's no surprise given the handsome rewards on offer.

[NA]

Great thread!

[Hackticus]

My wonder is how much of the hedge fund boom is driven by chronically underfunded pension funds who are desperately looking for some sort of miracle before the baby boom retirements breaks them.

[burritoboy]

SAC is essentially a high-level hedge fund incubator. SAC hires a lot of different people they think have potential (generally somebody who's been on the Street for a few years and made a mark), give them a small slice of capital, see how they perform over a year or so and gradually increase their allocations. There are at least two dozen teams within SAC, many of whom have little connection between themselves (though they all trade through one system). Different styles, instruments, industries, you name it. Most of them are not quant teams, though. Eddie Cohen is not a quant.

People should note that many of the larger hedge fund firms are like that under the hood. Pequot, Citadel, Angelo Gordon, Cerberus, Whitebox, etc. are effectively like that.

[Hedge Fund Managers]

Much of the hedge fund boom is driven by the fact that most pension funds are allocated too much directly into US or even globally diversified stock markets. They are so concentrated on one asset class that their portfolios don't bob and weave well during turbulent markets without hedge fund products or alternative investments.

- Richard
Hedge Fund Managers Blog
http://richard-wilson.blogspot.com/2007/10/hedge-fund-managers-pedigree.html

[Richards Hedge Funds Blog]

I think 1.25 and 20 is becoming more of the standard but large hedge funds often charge 2 and 25 or even 3 and 30 if they have 10-15+ year track records. Some small funds are offering 0/20.

- Richard