Once Upon a Time, Hedge Funds Were About Not Losing Money

Hedge fund performance has, for the most part, sucked this year. Read this article to see how the compensation schemes have done.

The standard fee schedule for a top shelf fund is 2% of the assets and 20% of the profits. Over time, the stock market returns about 10% per year.  Under a typical fee structure for a hedge fund, to generate a 10% return after fees, the hedge fund has to return nearly 15% before fees to attain the long-run average return of stocks after fees.

For example, let's say you have $100 to invest. On average, that $100 will be worth $110 investing in a passive stock index fund after one year.

If you are in a hedge fund that charges 2 & 20, then the fund takes 2% of your assets leaving you with $98 net of fees to invest. To generate $10 in profits after fees, the hedge fund taking 20% of the profits has to earn a return of 12.5% for a total of 14.5% in gross return before the manager earns the 10% one can earn investing in a passive equities fund. Thus, to add any value, the hedge fund manager has to earn at least 15% to justify your investment.

How easy is that? Warren Buffett - one of the world's greatest investors - has compounded his equity at just over 20% per year.  The average mutual fund earns 8%-9% per year. Consistently earning more than 15% per year is extremely difficult. 

How does the hedge fund manager get to 15% or more? A few do it by skill. Most do it with leverage.

And we have seen how well leverage has worked in the investment business over the past few months, eh? 

You can use leverage too if you want, either through the futures market or with leveraged ETFs, as long as you can stomach the volatility. Hedge funds used to be about not losing money. But as the article above notes, that is certainly not the case.

Comments

[john s. gordon:]

the premise of a hedge fund is to generate above market returns by taking above average risk (i.e., 30/1 leverage on commodities). for the last 13 months this premise has proven false. have the hedge-fund managers foregone their big fat fees when the performance is negative? noooo...
> jack

2008 Nov 13 08:56 AM

[notsosmart:]

these funds are the wealthy chasing more wealth.they should all collapse.what good are they?would we be hurt if if they are all gone? in the meantime our great leader"mission accomplished" & "im the decider" is busy deciding who to put on his pardon my cronies list.LOL

2008 Nov 13 10:08 AM

[john s. gordon:]

first item on agenda is presidential pardon for libby the scooter.
> jack

2008 Nov 13 10:44 AM

[notsosmart:]

johnsgordon is correct.

2008 Nov 13 11:15 AM

[Old Trader:]

There's been no shortage of pieces like this over the last 6-8 months, or so, but they all seem to have missed a single, and perhaps the most important thing. The very first hedge funds (going back to the 50s), pursued an absolute return strategy, so in theory, at least, they would never lose money, regardless of what the market did. By selling short, and/or going mostly cash, they could accomplish their goal. The downside to an absolute return strategy, is that it will lag in a strong bull market, due to the hedges in place at the market turning point, but it DOES give the investor a "smoother ride".

As various other strategies were developed and implemented, many (most?) hedge funds strayed VERY far from their roots. I think its very feasible for a small investor to pattern his/her portfolio along an absolute return model, given the variety of "hedging" vehicles available today (think short and ultra short ETFs as an example). I've had some reasonable success doing so, and I'm NOT an investment pro, and running my own (not market related) small business, can't spend all day at the computer "trading".

2008 Nov 13 10:41 PM