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While the fees charged by hedge funds (NYSEARCA:HDG) have come down some over recent years, structures commonly known as 2 and 20 (charging 2% of assets under management and 20% of investment returns) or even higher are still surprisingly common. At the high-end of the fee spectrum, Steven Cohen's legally-troubled SAC Capital has reportedly been charging an astonishing 50% of profits while hedge fund Renaissance Technologies reportedly has charged fees of 5%/44% (management/performance).

This article will make the case that hedge fund performance fees have created a value-destructive industry, in aggregate. It should be noted upfront, however, that I believe that some firms have and do justify their high fees. Furthermore, I believe that strong net performance will continue to be the case for the minority of hedge funds that systematically generate sufficient alpha to more than offset the negative return impact of their very high fee structure.

Misaligning Investor/Manager Interests

On the surface, a performance fee does make a lot of sense, which is why the structure is so popular. The more the hedge fund manager makes for you the more he earns - what a wonderful incentive for the fund manager to perform and make more money for you.

The problem is that the performance fee incentive can actually be very misaligned with that of the investors. Instead of incentivizing the hedge fund manager to make the most prudent risk/reward decisions for the capital of the investors, I believe that the incentive can often be to use aggressive leverage and take big bets which offer themselves substantial personal upside whilst personal downside is often limited (known as the "trader's option"). In other words, it creates a "heads WE win, tails YOU lose" dynamic for the hedge fund manager.

Think of it this way. Suppose you're in Vegas and a buddy tells you that he will provide the money for your gambling and share a portion of all the winnings with you. That isn't going to incentivize you to do what's best with the money (balancing upside potential and downside risks) since you benefit from the upside but don't share in the losses. Ignoring your (hopefully) natural desire to do what's best for your friend, the incentive of the arrangement itself would be to "go for it" and try and make a lot of money as the downside isn't your problem.

What is the Hedge Fund Manager's Actual Downside?

Of course, the situation for a hedge fund manager isn't as simple as the Vegas analogy, above. Hedge fund managers do face some reputational and job security risks from poor performance and they often do have some of their own capital invested in their fund. Moreover, many do have a sense of responsibility to do what's most financially prudent for the client and not just for themselves.

That said, I believe those factors are often more than offset by the allure and risk-taking incentive of "playing with the house's money." This is particularly true when considering how forgiving the hedge fund world is to managers that run funds that blow up. There are two main reasons why I believe that the downside for fund managers (resulting from poor performance) is less than many might expect.

First of all, after a trader leaves a failed hedge fund, there's always the ability to place blame elsewhere in the organization, particularly since funds can be so secretive and opaque about the details of what's happened. This isn't necessarily borne from dishonesty, but also from a natural human tendency to attribute blame for bad outcomes to others (and many times it may, in fact, be justified). Because of the secrecy of most hedge fund operations, the true story isn't always public knowledge and is often open to interpretation from ex-employees.

Secondly, it often seems that losing big sums of money really isn't necessarily that bad for a hedge fund manager's career. This follows the "no publicity is bad publicity" theory. Many investors conclude from a massive hedge-fund blow-up that: "He lost $10bn?… he must be really good to have been given the responsibility to manage that much money." and "He's obviously bright and now that he's blown up one fund… well, lightening never strikes the same place twice." By way of just two high-profile fund blow-up examples, I think that you'll find that the principals of Long-term Capital Management and Amaranth have done just fine in attracting capital since their respective blow ups.

My point is not that poor performance should necessarily mean the death of a hedge fund manager's career, but rather that the upside potential from taking on lots of risk (under a performance fee structure) can be much greater than the downside risks for the manager. Again, the interests of the fund manager are not aligned with that of the investors.

Destructive Strategies that Can Result from Performance Fee Incentives

So, let's look at the value destructive strategies that can result from performance fee incentives. The "big bet" tendency is the first and most obvious. To meet the high expectations of investors paying such exorbitant fees and because of the performance incentive structure, funds often take excessive risks through high-risk trades. This can involve putting too much leverage on a position, having positions that are too highly concentrated and/or correlated, taking on large naked option or short positions with too much downside risk potential, etc.

The real problem with these high-risk trades is the fact that they can place such a substantial percentage of the firm's assets at risk at any point in time, which includes profits already earned and reinvested in the fund. If you gain 20%/year for three years (compounding to a 72% gain) and then lose 50% in year 4, you're still down 14% (despite the greater upside % move relative to the later % downside move).

A second strategy is often referred to "picking up nickels in front of a steamroller" and refers to low return trades with a high probability of success, but with substantial "tail-risk" (i.e. low likelihood events, but ones, which could have severe negative consequences). These trades can also have a devastating effect on investors if/when the unlikely downside result finally occurs.

To illustrate this point, if you invest in a mix of investments with an expected 15% annual return, but there's a 1/10 chance of a 100% loss and you reinvest the returns and repeat the trade every year, you will eventually lose all of your capital. That's simply a statistical reality and a question of when and not if. I believe that many hedge funds have and do invest in a similar manner, though typically not that extreme and they often do so unknowingly by not recognizing the potential for and magnitude of the downside tail risk.

As such, this type of portfolio mix would be a horrible long-term strategy for an investor, but not necessarily for a hedge fund manager who may be able to cultivate the 15% returns (and take their cut) for many years until a blow up finally manifests itself. In any given year, you may be able to expect a positive result from this portfolio, but not in the long run. Furthermore, if/when the fund does blow up, the hedge fund manager doesn't have to give back the fees they collected during the good times.

Following big losses, the hedge fund may have prohibitively high "water marks" (limitations on receiving performance fees until they make up the losses) resulting from the down year(s), but fund managers and traders can always move elsewhere if/when their firm comes into a position where high water mark issues will hinder future bonus potential. Funds can also shut down and reopen under a different firm for the same reason.

Another problem is that the "picking up nickels" strategy appears to be low-risk as it can generate steady returns with low volatility for many years (an additional reason why the strategy can be so popular). This, in turn, produces great Sharpe and Sortino ratios (which measure absolute and downward volatility, respectively) until the often ignored and/or overly discounted tail-risk ultimately manifests itself and things blow up.

I'll give you two example of how I've seen these trades (not) work in the credit hedge fund world during the credit bubble. One popular credit hedge fund strategy was simply to use leverage to buy the secured bank debt (NYSEARCA:BKLN) of high-yield bond (NYSEARCA:HYG) issuers. These bank loans consistently traded right around par during the credit bubble, resulting in extremely low volatility. Demand for these loans was high and default rates were low, preventing downward movements in the loan prices while call provisions at levels close to par capped the upside price volatility of the instruments.

The yields on the bank loans weren't particularly attractive, so leverage was often used to enhance returns. Given the very low price volatility of these instruments, risk-adjusted returns using traditional Sharpe and Sortino ratios for this trading strategy looked great. All was wonderful until the credit bubble popped and many of these bank loans fell to 70 cents on the dollar and worse -- creating 30%+ in capital losses before leverage. Adding leverage to the mix and the losses were unsustainable for some hedge funds.

Another popular strategy was called a curve steepener using credit default swaps (CDS). Using some oversimplified assumptions/figures, it works something like this:

You would sell $20mn of 5-year CDS insurance for a bond at 300 basis points and buy $10mn of the 10-year insurance at 450bps, earning an annual carry of $150k. The weighting of the positions and correlation was such that the intermittent capital gains/losses from small spread movements in the different CDS positions would largely offset each other within a certain range of movement.

So, again, the strategy produced steady returns with low volatility for an extended period of time. The problem with the trade was that you were long (insuring) twice the amount of debt that you were short (buying insurance for). As a result, if the credit risk of the issuer substantially increased or decreased, such that the yield curve flattened considerably (or worse, there was a default), you stood to lose a fortune. And that's what happened for many of these trades when the credit markets ultimately blew up in 2008. Again, this apparent low risk/volatility trade was anything but low risk, but it was a great money-maker for hedge fund managers for a good period of time.

Is a Low Management Fee-Only Structure Any Better?

The short answer is yes. The lower the fees structure of a fund, the more the odds are weighted in an investor's favor -- all other things being equal. That being said, even the pure management fee structure has severe limitations, as has also been evidenced by the tendency for actively managed mutual funds to underperform the market.

The pure management fee of traditional mutual funds can have a very different negative dynamic for investors. Mutual fund managers often face a situation where they get a modestly higher bonus if they substantially outperform their benchmark index, such as the S&P 500 index (NYSEARCA:SPY), but face potential job loss if they substantially underperform.

As such, the incentive to stray from the index and expose themselves to job security risks isn't great. For that reason, many active mutual fund managers simply become what's known as "closet indexers" who maintain portfolios that closely follow the benchmark index with minimal tracking error (variance from the index). This, combined with the fees that they charge, is also a natural recipe for long-term underperformance.

Conclusion

So, what's the answer if both types of fee structures have such flaws and limitations? Well, there is no easy answer, but I'll provide some thoughts to consider before investing in any actively managed fund.

First of all, I believe that 2/20% hedge fund fee structures are unjustified much more often than not. In order to agree to pay such substantial fees, you really need to know and understand the fund manager's investment philosophy, source of alpha, and the manager's capital preservation and risk management philosophy and procedures. You also should believe in the manager's integrity and ability to do what's best for investors and not just for themselves.

Demanding strong historic performance is a start, but not enough. Many hedge funds will perform well (net of fees) for some time, but not from true alpha generation. These firms will perform from what efficient market theorists compare to the results of multiple coin tosses. In other words, if you have 100 million people flipping a coin and repeating the toss if/when they guess right, over 3,000 people are statistically likely to guess correctly 15 times in a row.

I am by no means an efficient market theorist. In fact, as a fund manager myself, I believe quite the opposite. Nonetheless, the fact that the strong performance of some funds will be the result of luck is a statistical reality. As a result, one great challenge in evaluating a successful fund's potential for continued success is determining if its track record was truly the result of systemic alpha generation or just excessive risk-taking combined with a streak of "fortunate tosses of the coin." This task is even more difficult when the hedge fund's investment strategy involves secretive "black box" investment programs.

One good way to better ensure that the fund manager's interests are aligned with your interests is through the manager's own substantial investment in his fund (and not just a token amount). If the investment is substantial enough, it can help offset the promise and allure of management fee profits that can be gained from excessive and irresponsible risk taking. I believe that a good hedge fund manager should, ideally, be incentivized through his own investment, in the actual fund, and through long-term success (growing the asset base) by providing long-term value for investors.

The ideal situation is to find a manager that fits the criteria above, charges modest fees (with no performance fee), and has an investment strategy that can be dynamic and doesn't tend towards closet indexing. Because of the need for diversification (i.e. not put too much in any individual fund) and the difficulty in finding such a combination, I believe that hedge fund investments should typically comprise a relatively small percentage of any investor's portfolio. And for most retail investors, I believe that a hedge fund allocation probably shouldn't exist at all.

With respect to traditional mutual funds, I believe that low-fee index funds should be the go-to option over actively managed mutual funds except in exceptional circumstances. Actively managed funds are an attractive option only when an outstanding manager is found who is investing under a platform that provides him with the luxury of being able to stray meaningfully from the benchmark index without the threat of job loss from short-term underperformance. I feel that a long-term investment strategy is of great importance as I believe that short-term momentum investing is essentially a "coin flip" and the only way to systematically outperform the markets, over time, is through research-driven value investing with a long-term horizon.

These situations, where fund managers are afforded the luxury to take a long-term view, can arise from smaller boutique funds that manage a lot of their own money and whose fortunes aren't completely tied to the short-term demand of (what can be very fickle) investor sentiment. They can also result from solid long-term track records (for large and boutique mutual fund managers, alike) which have allowed the fund manager to build up enough "goodwill" so that their jobs aren't completely dependent on short-term performance

In summary, I believe that finding both hedge fund managers and traditional mutual fund managers that justify their fees can be difficult, but they do exist. Obviously, there are many amazingly bright and intelligent fund managers (for both hedge funds and traditional mutual funds) in the investment world. That said, you really need to do your due diligence before investing in any actively managed fund and this is particularly true with high-fee hedge funds that may have less than transparent investment strategies.

Disclosure: Long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Unintended Consequences Of Hedge Fund Fees