Are Hedge Funds worth the cost?
Hedge funds have had a
rough time of it over the past several years. Since the markets hit the bottom
of the last correction in 1Q2009, hedge funds - particularly the timid
strategies making up much of the more recent entrants - have not kept up with
simple index trackers. A long, strong bull market is deadly for investment
vehicles promoting low volatility and low correlation.
Hedge fund performance since the S&P 500's trough in February 2009 has
been abysmal. It is no wonder this category is being abandoned by the large institutions.
Finding justification for a 2%/20% fee structure (or even side-letter deals of
1.25%/12.5%) is difficult in a flat-line environment.
It is a widely held belief – at least among the pundits whose profession it
is to infuse such beliefs into the larger community to the point that they
become "widely held" – that the 2% management fee/20% incentive fee
compensation model employed by most hedge fund managers fleeces the
unsuspecting investor. I disagree. Let me explain why:
Let’s start by acknowledging that the best known hedge fund managers are
incredibly, immorally and unconscionably overpaid. Their compensation has
nothing to do with their contribution to the product, the process, society or
the general welfare of anything. They were simply for the most part smart and,
in almost all cases, lucky. Luck may favor the well prepared but it's still
Most Hedge Funds are Small Operations
But let’s focus on the typical alt investment manager. Like many aspects of
modern economic reality, the population of fund managers breaks out in a 99%/1%
split, where the 1% makes it into the news when they corner a market or throw
hissy fits over some perceived infraction of Hamptons protocol or Manhattan
penthouse terrace etiquette, or end up with Cabinet appointments. The vast
majority of fund managers are eking out a (often quite comfortable) livelihood
doing what they love.
The typical fund manager is not running a vast empire. Median fund size in
the HedgeAlytix universe is currently around $34 million although the heavy
offset of the larger funds pulls the average fund assets up to around $87
million. In all, there are some 20,000 pooled vehicles globally chasing
somewhat over $3 trillion, or an average fund size of $150 million; this is
counting all the in-house or otherwise private capital essentially invisible to
the outside world.
The reason for this is quite simple: starting up an alternative investment
vehicle is an easy process. All you need is skill, experience, perspicacity –
and access to money. Twenty years ago, when the industry was still young, most
hedge funds started at the kitchen table with assets provided by friends and
family. Most still do, although many are fortunate enough to lock in promises
of seed money from a school, pension fund or other small institution, typically
in exchange for some form of sweetheart deal.
Most Hedge Funds are Barely Profitable
The 2% management fee for a $34 million fund generates $680,000. That must
not only cover the expenses of two or three employees but it must also support
the entire undertaking, including legal fees, administrative and audit
expenses, rent, insurance, data access and equipment, etc. It gets chipped away
quite quickly, even with the soft dollar inducements offered by prime brokers
and other service providers.
Several funds have attempted to institute a sliding scale of fees based on
total assets. In most cases, these schemes fell apart in the implementation
stage; typically devolving into "retail" and
"institutional" classes where lower fees were tied to higher capital
contributions and/or reduced liquidity. The bottom line is that the change in
actual results from a management fee dropping from 2% to 1.5% is insignificant
to the investor while the difference in revenue can be huge.
It’s the Huge Marquee Funds That Make the News
The 20% side of this fee structure is a different story. For example, one
of the first successful commodity pool operators was Paul Tudor Jones, II. When
he and his partners organized their investment vehicle, The Tudor BVI Fund Ltd,
in 1986, it was based on an annual management fee of 4% and a monthly
performance allocation of 23% of trading profits (without a high water mark).
Tudor made the news last May by announcing that it was reducing its performance
fee down to 25%. The firm has over the past several decades grown to an
enormous size – they are currently at around $11.6 billion in assets which at
their base management fee of 2.75% yields some $319 million annually before any
performance-based allocation – and had increased its base performance
allocation to 27% of profits. Just a quick jot on the napkin would reveal that
if the Tudor fund(s) scratched out an industry average gain of 10% in 2014,
that would have resulted in a payday of another $300 million or so. Of course,
managed futures in aggregate lost almost 1% in 2015, so they would have only
seen performance allocations in the six months where they gained, rather than
lost, money; my understanding is that they still take monthly allocations and
they still are free from a HWM barrier.
Performance fees can be difficult to justify, particularly for very large
funds. However, if the fee is based on performance above a justifiable
hurdle rate then it can make sense for an investor. A rising tide raises
all boats… For the smaller fund manager, the ongoing management fee should pay
the bills of the business and the performance fee is a bonus for doing a great
job. If the allocation is based on returns above the investors’ expectations or
requirements, then everyone is well served.
What Went Wrong?
Hedge funds went mainstream and became milquetoast. Most of the newer
entrants to the category are either broadly diversified multi-manager vehicles
or faux hedge funds; high liquidity, restrictive stop-loss provisions, and policies
conforming to the "investor protections" of AIFMD. The money, which
these days comes from conservative institutions and retail investors, is
focused on these Liquid Alts. Hedge funds have become virtually
indistinguishable from regular funds.
Hedge funds need to get back to basics. I am confident that the long/short
strategies, managed accounts and commodity pools that made up the original
category will survive and prosper. Faux funds with no unique investment
proposition will continue to wane. And, more important, smaller boutique funds
are returning to the fore; huge marquee funds with plain vanilla strategies can
no longer justify their existence.
When you break down the
hedge fund space to individual entities, the picture looks much different:
The right side of this field is filled with funds worth investigating.
HedgeAlytix was designed to help sophisticated investors find their ideal
fit. We focus on independent advisors operating strategies appealing to wealth
management groups, family office operations and highly qualified individual
investors. These are markets we know quite well and since 2001 we have been
offering our clients institutional strength analytical tools to search for,
evaluate, compare, combine and track these investment opportunities. We also
have mechanisms allowing investors to contact managers of interest, and vice
We are entering interesting times.