The Bull Case for Hedge Funds (Yes, Hedge Funds) 19 comments
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The one group of investors that's been vilified more than any other by the business press and government officials alike in 2008? Hedge fund managers.
After years of rapid growth in terms of both assets and numbers of funds in operation, the hedge fund industry has taken a PR black eye this year. Media reports would have you believe that the industry is about to collapse in size, see its revenue drop dramatically through fee reductions and become heavily regulated to protect unsuspecting investors from another Bernie Madoff scam.
Hedge funds certainly make an easy target. They've had a bad year, along with every other retail and institutional investor. But the industry is about to grow dramatically over the next five years. This coming year will mark the beginning of the next wave of this industry's growth.
The 12 months of 2008 have proved an abysmal year, and every investor can't wait to be done with it. While hedge fund managers have done terribly, no one in the media seems to criticize the mutual fund managers or other wealth advisors for lousy performance (with the exception of maybe Bill Miller).
It seems to be an unstated opinion in many articles that hedge fund managers should know better than other investors. One simple reason for this, a reason that draws endless attention and criticism, is hedge fund manager compensation. It's true that the best-performing fund managers over the last few years have been well compensated.
I don't have a problem if a hedge fund manager, the CEO of Yahoo! (YHOO) or the head of risk management at Citigroup (C) gets paid boatloads of compensation year in and year out, on two conditions: (1) they should only be paid well based on their direct contribution to the performance of their firms, and (2) that performance should be "real" performance, meaning that there is real value created, not some illusory accounting profit.
Hedge fund managers have an advantage over those who hold the types of positions mentioned above. First, as with a sales rep, you always know how a hedge fund manager is doing. With the exception of managers that dabble in private equity or illiquid assets, which are more difficult to manage on a daily mark-to-market basis, any hedge fund investor could get a daily report on how a manager is performing.
And hedge funds -- even the big ones -- are still small shops. If a fund has a good year or a bad year, its manager, whether it's Stevie Cohen or Bill Ackman, gets the credit or the blame. They don't get to punt responsibility to a foreign office or a snowstorm that kept away retail shoppers.
The second advantage hedge fund managers have over others when it comes to their compensation is that their performance is "real" at the end of each calendar year. Simply put, the market value of your portfolio this year gets measured against last year's market value. Whether or not these profits were aided by leverage, hedge fund managers must perform in order to be compensated. While others can use their political skills to keep their jobs, hedge fund managers have to live with their fund's performance and the consequences that performance brings.
After a disastrous 2008, the big commercial banks are holding back recently injected capital from taxpayers to pay out year-end bonuses. However, few hedge funds (with the exception perhaps of the 10% that made money this year) will pay out bonuses.
What's more, many of the hedge funds that lost money for their investors this year adhere to "high-water marks." This means they have to make back their 2008 losses in 2009 before they are eligible for future bonuses. Investors get made whole and their managers only get bonuses when they actually deserve them. Citigroup investors sure wish they could get that kind of arrangement.
Hedge fund managers -- unlike mutual fund or other private wealth managers -- get paid for performance, not assets. Their incentives are perfectly aligned with their investors. They make calculated bets and expect to be highly compensated only when they succeed. This arrangement has attracted and will continue to attract talent. The best managers will migrate to hedge funds because they can be more successful financially.
They also accept the financial and reputational pain of performing poorly. Even with less leverage and more regulation, the hedge fund industry is still the best game in town for the most talented managers.
And it's also the best game in town for investors -- which is why the industry is set to begin its next wave of growth in the next five years. The most sophisticated investors still need help managing their money. They are not going to hoard Treasury bills forever.
Do you want to invest in a mutual fund manager incentivized to grow assets but not necessarily performance? Would you not, if you had the opportunity, want to invest in the best qualified money manager?
It's true that Bernie Madoff's Ponzi scheme has shaken the trust of investors in all money managers, and that will have a fallout effect on hedge fund managers. However, the hedge fund industry will be much bigger in 2013 than 2008.
Here are some other fearless predictions for the industry:
- The number of hedge funds will decrease by 30% between the start of 2008 and the start of 2010, but the assets under management will actually increase as investors seek out the best managers.
- This growth will come at the expense of the mutual fund industry and wealth management.
- The due diligence industry, which researches hedge funds and their managers, will quadruple in size. Today, there are few firms with expertise in this area (Due Diligence Consulting, Kroll and Backtracks are on a short-list of firms with expertise in this area). Investors will need to invest in hedge funds, but won't be able to rely on the Securities and Exchange Commission to conduct their due diligence. They won't mind paying for this work themselves.
- The "2 and 20" fee structure for the industry (under which hedge funds charge 2% annually for management fees and 20% for the share of the profits created) will persist. Investors will not object as long as they receive the performance they expect.
- Fund-of-hedge-funds will be most negatively affected by 2008. Larger institutional investors will become much more hesitant to invest in fund-of-hedge-funds over the next two years in the wake of the Madoff scandal for fear of criticism from their own investors. These types of funds will not go away, but there will only be so many people that can say, "I can get you into John Paulson's fund."
- There will be more hedge fund regulation from Washington but not to the extent that it kills the industry. What purpose would that serve the Obama administration? A greater administrative burden dealing with new regulation will become the new cost of doing business for hedge funds. It will make it harder for newer/smaller hedge funds.
- Hedge fund managers will become better risk managers and learn to perform without the benefit of leverage. Those with enduring strategies that can create value will grow.
Hedge funds are not going away. They're actually going to greatly increase in size over the next five years. The level of dissatisfaction in mutual fund managers and private wealth managers will cause investors to seek out better-performing investment vehicles for their cash. Although there will certainly be changes to the industry as a result of the events of 2008 -- including hedge fund failures in the next six months -- the future looks very bright for hedge fund managers and their investors because their interests are so well-aligned.
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This article has 19 comments:
This is a really good contention to bring up. Even so, hedge funds compensation is an issue. They make large sums for when they are above the mean even if it's just pure luck. Thus if they are 50% above the mean and 50% below they suck away their investors returns when they are above making their client's returns below par if you factor in their down performance. All while touting their Madoffish magic.
Many know it's a random number game. In fact if you look at a lot of pre-hedge funds what do you see. Guys running 10-20 portfolios, picking the 2 that beat the standard deviation and then opening to investors touting their great ability. It happens every year. You never see the 18 loosers. Nor are you aware their performance being maybe slightly better than average often declines back down to the mean leaving investors in a lurch. How many managers do badly, then appear a few years later in another fund. Tons...
True there are some good investors possibly. Maybe they are extraordinarily lucky. Maybe we should pay a premium for luck. But they are often in a basket will a lot of greedy sour lemons that are sluping off the risk reward investors are taking.
I'm a big believer in skin in the game. If their investing strategy is so great I may invest if they put 100% of their savings in it. Look at their savings. Most all of it is not in their own "wonderful investment vehicle". And why not? Don't ask me, ask them.
I'll stick to self investment. I don't pay capital gains until I sell the stock and I can liquidate losses to offset other capital gains like interest. That in itself gives me an edge over the tax structure of any mutual fund without tax deferral or matching funds. It's not that hard to diversify. Pick up a few good investment books and start reading.
Thank you.
P.s. Most hedge funds have outperformed mutual funds as a whole.
Call it what you want, hedge funds accelerated the accumulation of leverage, hence risk, and even though there are a couple good apples, the industry's bad will quickly fall from the tree which may implode the rest of the industry.
It is utterly premature to start calling bulls, bears, and pigs. The truth is that no one knows the future of Wall Street, and positive spin in an effort to save an industry is only propaganda -- a self preservationist chasing after the wind.
Increased regulation will only accelerate this structure as the cost of doing business will only increase. Only the larger fund will have the scale to support the infrastructure, personnel, reporting systems and risk management systems needed to meet likely reporting and compliance standards.
As an aside, I think the current and likely future environment will make it difficult for even the best frims to enjoy consistent returns realized in the past.
alphadominance.com
Hedge fund managers still charge 2%, more than most mutual fund managers. You think that doesn't incentivize them to grow AUM as well?
And performance fees. Here's the hedge fund deal - you have to share a healthy chunk of the upside with me, but you have absolutely no downside protection, and could in fact risk not being able to withdraw your money, at my discretion.
Hedge funds should not be unduly made a scapegoat for what was after all mostly the sins of bankers. But it's still a rigged game, where the house takes a cut of your winnings but you could lose everything.
All their ivy league managers knew was to leverage like crazy with money borrowed from once conservative but greedy banks and together with their pals push up the price of everything they bought through sheer weight of investment and then kid themselves (or rather their investors)they had made a real profit and take a 20% + cut of it! This is not investment- its buying the shop. There is one, and only one, thing to know about overall stock market performance which you can bet on. That's that the more the money supply the more stocks will go up. The less money supply then the more they will go down.
This of course, is utter nonsense and it makes one wonder which planet the author lived opn over the past 10 or so years. the 2/20 hedgefund manager crowd enjoys a risk-reward profile that is even more unfairly skewed in their favor than that of top level corporate officers. heads i win - tail you lose while i keep the profits of the past years is the mantry of many, many ,many hedgefund managers. It pays them to make highly risky bets that may pay off just once - and kill the fund and investors just a few months later.
my prediction,. instead: as long as that 2-20 self-serving payout structure is not substantially changed, the hedge fund industry will decline. Most of their returns were achieved with high beta(unsustainable and cheap leverage) and very little alpha. Gone are the days that this kind of business model earned big returns for little real performance. It's much like with the investment banks.
do hedgefunds have a future? of course, you bet they will have. but they will look different than todays 2-20-crowd, or else they will be a thing of the past
9. The hedge fund and fund of funds industries do not recover in 2009. The Madoff fraud, poor hedge fund performance and renewed controversy regarding private equity marks (particularly among a number of high-profile colleges like Harvard and Yale) prove to be a short-term death knell to the alternative investments industry. As well, the gating of redemption requests disaffects high net worth, pension plan, endowment and University investors to both traditional hedge funds and to private equity (which suffers from a series of questionable and subjective marking of private equity deal pricings at several leading funds). Three of the 10 largest hedge funds close their doors as numerous hedge funds reduce their fee structures in order to retain investors. Faced with an increasingly uncertain investor base, several big hedge funds merge with like-sized competitors in a quickening hedge fund industry consolidation. By year-end, the number of hedge funds is down by well over 50%.
I have seen a haunted house, would you like me to return to live in one?
we track hedge fund portfolios/performance on our blog and after sifting through all the data feel that a consolidation in the industry is healthy and natural... and inevitable really.
www.youtube.com/watch?.... copy and paste to your web browser , or click on my website
Yeah, no new money just lay waste to the unwashed mutual funds!" If they're so great why are they also in deep trouble? It's just another aristocratic means to exclusivity--as bad as partnerships. You're deceiving yourself into thinking hedge funds are any better than mutual funds which most try to avoid exotic, exclusive investments. Why don't they come to the rescue of GM--which will again be a powerhouse? No, real issue investments in things that matter the most to the nation are foreign to them. Enjoy, you're new born again religion while you can because eventually investors will tire of handing them 20% of their gains.
Managers are not going away......investors will just seek honest and credible ones.
First, the 2 and 20 structure is fundamentally flawed and most hedge fund managers are indeed changing the terms to attract new capital. There is just too much competition for new money that everyone so desperately needs, and it is the reality that even the best performing hedge fund managers are being pushed by potential investors to change the terms. Either way, the 2 and 20 structure is flawed because managers receive an incentive fee for any positive performance, effectively getting compensated for beta. Someone writing for Seeking Alpha should know that such compensation structure doesn’t make sense. In addition, there is frequent misalignment between the annual cycle for the manager’s incentive compensation and both the investment time horizon. Finally, unlike PE managers, hedge funds pay themselves incentive fee compensation on unrealized appreciation (i.e. paper profits) as well as realized gains.
Second, fund of funds and due diligence they provide are worth the extra layer of fees. Due diligence is more time and cost intensive than many people think. Fund of funds provide a due diligence and diversification service, making it possible for smaller investors to profit from hedge fund opportunities. In fact, this is the time when most sophisticated investors are taking capital away from hedge funds and putting it into fund of funds. If everyone just invested in fund of funds to begin with, perhaps investors wouldn’t be hurt as badly… Diversification matters.