The Good and Bad in Hedge Funds Today: A Manager's View

Not too long ago, practically every newly minted MBA wanted to be a hedge fund manager, and investors—including many conservative pension funds and endowments—rushed at the chance to place assets in hedge funds. Yet hedge fund managers were blamed for both artificially inflating the price of oil last summer and, when prices dropped, for contributing to the looming recession.

The mainstream press has now taken to derisively calling them "former masters of the universe," while noting that compensation is still "obscene." As quickly as assets came in during the up market, they have gone out in a declining market. In the last quarter of 2008, $152 billion in hedge fund assets were redeemed, even ones with positive returns in 2008.

As a hedge fund manager, I'm neither an apologist nor a cheerleader for my industry. Like any business, the hedge fund world has good and bad practices and managers. All managers need to accept accountability for the trying times we are living through. But it's fanciful to suggest hedge funds are about to disappear. Quite the opposite: The industry will be thriving even five years from now because it will continue to attract the best managers and the most sophisticated investors seeking alpha through innovative strategies. Here are some of the good and bad practices in the industry today:

Barbarians at the Gates

Hedge funds have long had "gates" as options available to the fund and/or manager included in their subscription documents. All investors reviewed these prior to making an investment. You haven't heard much about them because hedge funds haven't gone through a sustained down period the way we have in the past six months. As a result, a number of funds have exercised their rights to enforce a gate, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.

Gates are a perfectly legitimate operating mechanism and will continue to be part of hedge fund investing. Moreover, as so many funds have decided to use them in the past four months, it is unlikely any one fund will be unfairly penalized by investors when they raise new funds down the road. The managers who will be penalized for putting up a gate are the ones who continue to charge fees after doing so. That's their right under their agreements, but it certainly doesn't engender goodwill, and investors tend to have elephant-like memories.

Overpaid and Underperforming?

Critics have attacked the standard hedge fund compensation model of 2% annual management fee and 20%-of-profits performance fee in light of the industry's poor 2008 performance (-19.2% for the average fund, according to Hennessee Group). Yes, many hedge fund managers made bad calls in 2008, but one-third of hedge funds made money in a year when the Standard & Poor's 500-stock index was down 40%. Only 1 in 1,700 mutual funds made money in the same period, meaning you were 50 times more likely to make money in a hedge fund compared to a mutual fund last year. What is that worth in fees?

Sadly, some hedge fund managers don't help themselves in the court of public opinion. Call it John Thain-itis. Many media profiles of hedge fund managers mention private jets, homes in the Hamptons, and flashy lifestyles, none of which has any predictive value about whether a hedge fund is a good investment. It's always been about the returns over a specific period of time, and the comparable risk-reward of other alternatives to invest their money.

Eying High-Water Marks

Hedge funds typically have high-water marks, which require hedge fund managers to make their investors whole before paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years.

What high-water marks also do—from an investor's perspective—is level the differences between a hedge fund and a mutual fund or other asset manager. Any investor has to pay a percentage of assets in management fees to a money manager. In the case of hedge funds, an investor pays performance fees only when the manager makes money. Investors also know that hedge funds will invariably attract more talent because the compensation levels are higher than the mutual fund industry or elsewhere.

Some observers feel that high-water marks are not the panacea they seem. In a down year, they argue, you can just shut down your fund to avoid the pain of making back past losses and open up another shop across the street. Although this can and does happen, it's just as common for hedge funds to honor their high-water marks instead of taking the easy way out and shutting down, eliminating the high-water mark, and reopening later.

Bottom line: If managers screw up, they need to face the consequences. It's that kind of Darwinism which makes the industry strong. Investors shouldn't have any qualms about having to pay performance—or more correctly stated, revenue-sharing—fees.

Reconciling Differences

With over 10,000 hedge funds worldwide in 2008, funds naturally vary in size and strategy. Some pursue absolute returns, always seeking to grow capital, no matter the market; others aim to beat the S&P or other benchmark on a relative basis. Absolute and relative performance strategies have different levels of volatility due to the different types of risk they take on.

James Simons of Renaissance Technologies recently announced that his firm would not charge fees to existing investors for its Institutional Futures fund, which was down 12% in 2008, but would still charge fees on its Institutional Equities fund, which was down 16%. The difference between the two funds? The first follows an absolute return strategy, while the second aims to beat the S&P 500 by 4% to 6%, which it did.

There is no question that there's a sea change taking place in the hedge fund industry, which saw its assets decline by $782 billion, to $1.21 trillion, in the past year. That's a Detroit-like drop in demand on a year-over-year basis. Within five years, it's likely the mega-funds will dominate, similar to the private equity world, where you have KKR (KFN), Bain, T.H. Lee, and a lot of small fry.

Man Group in Britain will be the model for the biggest U.S. hedge funds, running multiple strategies and catering to the institutional investor and pension fund community. It's likely the funds with more than $5 billion in assets today will assume the mega-fund mantle in the future. Funds under that level will shrink or sell out. However, niche hedge funds will continue to thrive, as long as they have unique strategies that are successful.

Most will prosper with a couple hundred million dollars in assets, although some niche strategies can handle up to $2 billion. This is where a lot of innovation and outperformance in the industry will emerge. For example, the most feted hedge fund manager of the past two years is John Paulson, who made billions betting on credit default swaps, which predicted the severe souring of the housing market.

Prior to 2007, Paulson's firm was best known for its unremarkable, yet steady positive returns and merger arbitrage expertise. It's likely that he couldn't have made his bearish housing bet at a bigger shop. The perceived risk he was taking on with the CDS, especially going against the conventional wisdom at the time that housing would rise steadily because it always had in the post-World War II era, would have been rejected. Investors will be always on the lookout for the next great manager whose wave they can ride—and it will come from the smaller, more entrepreneurial managers.

Nothing Personal

Here's a scary thought for hedge fund investors: Hedge funds domiciled offshore (e.g., in the Caymans or British Virgin Islands) have boards of directors that tend, in my experience, to be far more lax and chummy than most corporate boards. (U.S.-based funds typically do not have boards as they operate as general partnerships.) These offshore boards tend to be small, typically two or three people, one of whom is often the hedge fund principal. Since the board oversees the investment manager's mandate, this is a huge conflict of interest that most hedge fund investors don't talk about.

Although it would be wrong to have a large bureaucratic board for a relatively small and entrepreneurial organization like a hedge fund, small boards often encourage managers to ask "friends" to fulfill this role. As a result, board meetings tend to be informal, tough questions don't get asked, and a real debate of legitimate risks facing the fund is avoided.

Many funds end up appointing a "rent-a-director" who lives locally and usually is recommended by, and affiliated with, the offshore lawyer working for the fund. These professional board members often have no job except serving on dozens of similar fund boards. They are simply there to be paid, so they clock in and clock out of meetings with a 9-to-5 mentality that would make a Dilbert character blush.

There are excellent hedge fund directors. However, perhaps not as many funds would be imploding this year had their boards done a better job at holding managers' feet to the fire when times were good.

Slimming Down

The hedge fund industry will be working off its "too big, too fast" growth in the coming years. We're going from 10,000 hedge funds to perhaps 6,000 in the next few months. Performance, operational, and increased regulatory issues will weed out one-third of all hedge funds within two years. Remaining fund managers will have fewer staff, less leverage, and less compensation.

Those hedge fund managers with creative and differentiated strategies (and a track record and a background check that pass due diligence muster) will always find investors. Anyone worth their salt will stick it out; the dead weight and hangers-on will leave. That will make for a better overall industry.

Amid this upheaval and in the wake of the recent Bernard L. Madoff scandal, two hedge fund-related service providers will flourish: (1) third-party administrators who independently calculate a fund's month-end net asset values (NAV) for investors, and (2) third-party due diligence consultants who will scour the backgrounds and documents of fund managers looking for red flags to warn potential investors. I am amazed that these are still not considered absolutely required by investors before making an investment.

Who will wilt: the big fund-of-hedge-funds. Investors want managers who create value. Middlemen who take margin out of the value chain will be forced to defend their existence. Maxxam (MXM), Tremont, and Fairfield Greenwich showed us through Madoff that too few funds-of-hedge-funds do meaningful due diligence on the investments that they promised their partners. Funds-of-funds won't die but will drop away in large numbers. Only those that are truly differentiated will survive.

Investors will (and should) place more conditions on fund managers and demand more transparency. Although it will be much easier to do this in a post-Madoff world, an investor's size relative to other investors in a fund will still determine his power to demand this transparency.

Registration Debate

Politicians on both sides of the aisle have called for more oversight on hedge funds, including a suggestion for mandatory "registration." What would registration really accomplish? Many hedge funds will continue to reside outside the U.S. and not need to register. But the largest hedge funds—with a majority of assets—in the U.S. already have registered and file their 13-F list of holdings on a quarterly basis. Registration for registration's sake, giving the government an abundant amount of data to do nothing with, seems a waste of time. Madoff, by the way, was registered with the Securities & Exchange Commission.

If the government wants to help improve capital markets, they should be prosecuting scammers and Ponzi schemes like Madoff, preventing "naked" short-selling abuses, and making it easier for shareholders to oust lazy and nonperforming members of corporate boards.

The hedge fund industry will work out its excesses carried over from the past five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons will be learned. And investors will continue to flock to hedge funds because the industry will continue to attract the best managers with the smartest strategies.

Comments

[logicalsinger:]

I am less sanguine than you about the future for two reasons:

1- the bear market has shown that a vast majority of hedge funds that outperformed in the good years did so either by pushing illiquid stocks upward (think small caps and emerging markets) or by using a lot of leverage.

2- the biggest scam with hedge funds has been the fact that they charge a performance fee on UNREALIZED gains (unlike private equity funds which charge only on realized gains). A manager who was up 20% in 2007 but down 30% in 2008 still walked away with a large compensation. High water marks are not sufficient for reasons you discuss, and in the future, there will be more clawback and escrow provisions so that a loss in year 2 will mean that the fee taken out in year one will have be partially or fully refunded to investors.

All in, I think the hedge fund business has seen its best days in a generation.

Mar 05 08:11 AM

[pacman1947:]

Eric,
I'm speechless.

You say that regulation and disclosure isn't necessary. You say that 10,000 funds exist that don't need transparency and oversight. You say that most are offshore, so no EU or US overseer would have jurisdiction anyway. You say that the markets were not affected by hedge fund traders that have no restrictions of any kind on their trading techniques. You say that gates are imposed to trap the investors in the funds when things go south.

Sounds like you need to talk with some folks who are supposed to oversee the securities industry. Legislators would be very interested in placing restrictions on hedge funds by lets say, forbidding access to our markets by the hedge fund traders. IMHO, that would just be a starting point.

Mar 05 08:14 AM

[Nick Gogerty:]

nice article and covers the major points well. To the earlier mentioned poster, the largest collective loss set to exceed $1 trillion is in the highly regulated banking sector. Hedge funds love em or hate are private contracts between individuals. Limits do need to be put in place so that systemic risk a la LTCM isn't allowed as that means the public purse bears the brunt. In my mind it will be important to have independant actors "hedge funds" stepping into the breech where other entities may fear to tread. The more public (nationalised) the banks become, the less you can imagine them taking some important risks and offering liquidity to various nooks and crannies of the marketplace.

Mar 05 08:45 AM

[ResourceWise:]

Hi Eric, thanks for providing outsiders like me a little peek into your esoteric world of high finance. A few questions spring to mind:

1. While hedge funds protect themselves from a ‘run’ by using gates - why do they simultaneously insist that short-selling i.e. selling shares that they do not own with the explicit purpose of driving down share price, is a good practice? Other than creating a ‘run’ on the victim’s shares and in the process making large sums of money for the hedge funds, short-selling seems to serve no useful economic purpose. Or does it? Moreover if hedge funds are such vociferous advocates of free markets why not allow investors to withdraw their money as and when they want it back?

2. Why charge a 2% fee irrespective of whether the investments make money or not? Hedge funds claim to make money in both rising and falling markets, in which case they should put their money where their mouth is and stick to the 20%-of-profits performance fee.

3. Experts seem to suggest that high-leverage by governments, banks and consumers have contributed to the severity of the financial crisis. What has been the contribution of hedge funds to this high-leverage?

Your response to these questions will certainly add to the general awareness of Main Street and the media. Thanks in advance!

Mar 05 08:51 AM

[raytayzmd:]

..."Here's a scary thought for hedge fund investors: Hedge funds domiciled offshore (e.g., in the Caymans or British Virgin Islands) have boards of directors that tend, in my experience, to be far more lax and chummy than most corporate boards."...oh, please!...name a corporate board of ANY listed company that ever has done anything more than rubber stamp whatever senior management decided!...boards of directors need to be held legally AND financially accountable for any failures on the part of management...when management screws up, boards should suffer MORE than the shareholders whose interests they are supposed to be protecting.

Mar 05 09:48 AM

[bmesco1:]

Sir,
Why don't you go back to school, get an engineering degree, and start trying to actually create products or systems that people are willing to pay for either to make their live easier or less costly or more entertaining? To hold a job with the simple reason to try to gain personal wealth by getting between people and their money is not very noble. Is it ever difficult for you to sleep at night?
Bmesco

Mar 05 10:31 AM

[Jun:]

Personally, I dont the 2/20 structure is the problem. The problem is the benchmark they use. There had been many academic papers on hedge fund betas. If you are paying someone 20% performance for beta exposure then there is cheaper ways to do. The investment banks (or banks formally known as investment banks) will creat something for you at a fee far lower than that.

True alphas should be rewarded as long as the alpha is measured against the right betas.

Mar 05 10:48 AM

[curecell:]

After Maddoff and Standford, people who put their money in a hedge fund deserve to be parted with their money, and rightly so.

Mar 05 10:53 AM

[Alex Salkever:]

Hedge fund performance, in my mind, has always been fungible in terms of comparisons. That's because when a fund blows up, it gets removed from the tally. Further, funds are self-reporting returns so naturally, they don't report when they have bad returns. If funds were FORCED to report, then claims that they collectively outperform the mutual or index funds would be validated. Without objective comparisons, hedge fund claims that their returns are superior as an asset class, should be taken with a grain of salt.

Mar 05 01:06 PM

[Harry Tuttle:]

The comparison with mutual funds is not relevant because hedge funds claimed to be "total return." If they are not "total return" the fee structure of 2+20 is unjustified.

In the end, most hedge fund managers made a boat load of money by charging 2+20 on a leveraged portfolio, which is a ridiculous proposition for any investor. In addition, many are now abusing the gate-clause by refusing to return money to investors even though they have the liquidity to do so while STILL charging 2% for the "management."

Mar 05 03:11 PM

[Gtarras:]

Many many pockets of the financial industry will see either total destruction as a business model, or will be greatly reduced in size. Not because of regulation. Simply because of the reputational damage they have sustained in this mess. I can think of monoline insurers, SIVs, and yes, hedge funds.

Mar 05 04:02 PM

[User 370627:]

Moron,

The Madoff feeder fund you are attempting to refer to is Maxam, and the promoter involved was Sandra Manzke. That company has absolutely nothing to do with the listed company Maxxam (MXM), which was once an activist target of Alan Kahn, is run by Charles Hurwitz, and has no fund of funds business, much less Madoff involvement.

Exactly how much money do you run?

Mar 05 06:04 PM

[vaughn:]

What comes around goes around. Once gated, twice shy.

Mar 05 08:03 PM