It's Not the Fault of Hedge Fund Managers That They Make So Much Money

Andrew Clavell gets to the point on the subject of hedge-fund managers:

I don't begrudge the General Partners their loot one iota. What the academics fail to understand (choose to ignore?) is that the General Partners' business model is "to raise money at 2+20", not "to deliver alpha". Theirs is a sales job at which they have been particularly proficient.

Clavell's quite right. Given the choice between falling fees and higher alpha, on the one hand, or rising fees and lower alpha, on the other, hedge-fund managers will always go for the higher fees.

In fact, the alpha is irrelevant, since even the managers themselves don't really know what it is or whether it exists. Their job is to persuade investors to hand over lots of money, and the best way they've found of doing that is to talk about this thing called "alpha." It's silly to blame hedge-fund managers for the industry's high fees: The people who deserve most of the blame are the hedge fund investors.

Comments

[mdamdaol:]

To me alpha means doing better than I would do myself managing a given pot of money. (In the research world, one would call this comparison "on an intention to treat basis."). The 2/20 has to be measured in several ways
1. What is the time saved by delegating day to day investment management to someone else (and the value of that time if you can work at a given hourly rate then reinvested)
2. How much better would the managers do than YOU would do (as opposed to an arbitrary index) unless you invest only in index funds. (I am personally a lousy trader)
3. What is the psychological benefit of not being a trader. Don't underestimate the mood altering affect of watching trade after trade whipsaw your assets down in size. There are very few truly good traders out there. I am not.
4. What is the cost of the management of the mutual fund or other investment against which you are comparing the hedge fund. Funds usually have lower transaction costs and in case of futures can also generate interest income on cash held. Most mutual funds have at least a 1% annual cost and many actively traded funds near 2%.

Bottom line for me is that I view the 2/20% fee structure as part of the cost of a business model. I am able to participate in several businesses with a relatively modest investment in each with very little active management hassle. I have more time to work in my primary job and see my kids rather than reading charts all night and staring at computer screens all day!

2008 Apr 05 08:59 AM

[Yossel:]

What a delightful, enlightened and balanced assessment! Many thanks and all good wishes!

2008 Apr 05 11:36 AM

[hollowman:]

Silly me, I keep forgeting that it is NEVER Wall St fault - EVER!!!

It's all the pressure that they feel from the investors, and the biggest pressure is how to bilk them out of more of their money.

Poor Wall St guys.

2008 Apr 05 02:00 PM

[Zachary Sch...:]

While I agree that the 2 and 20 fee structure can sometimes be a bit excessive, I actually disagree with your assessment that managers are motivated only to raise assets. If a manager runs $100m and has a 10% year, he will make less than the same manager with $75m and a 20% return. The basic premise is that managers should line their own fortunes up with investors so that if investors have a good year the manager will be well compensated. I personally advocate a lower management fee while keeping the incentive fee high to properly motivate management.

Conversely, mutual fund managers can have a significant conflict of interest in that they are compensated based solely on assets under management. In most cases, the manager has very little incentive to produce above average returns but every incentive to spend time meeting with prospective clients to bring in more assets. This isn't exactly the recipe for strong investment returns.

Just my opinion.
Zach
zachstocks.com

2008 Apr 05 02:15 PM

[jerry p:]

agreed. the investors know what the fees will be before they invest. it is up to them whether they want to pay 20% to let somebody gamble with their money.

2008 Apr 06 12:02 AM

[mathieugp:]

The 2/20 fee model may be hard to pay when ROI is lower than 125% of the benchmark. Nobody is talking about the watermark, which is the most important thing when talking hedge fund fees. And yes, the hedge fund manager or mutual fund manager only want a bigger AUM, until they've reach the maximum efficiency level. Managers all know that the best way to get more assets, when you are already in business, is not to meet potential client but to deliver BIG numbers.

2008 Apr 06 07:16 PM

[pharma:]

There is something else to have in mind. Fund managers' compensation based on annual [single year] performance does not make much sense.

Good many funds produce extraordinary performances one years and very terrible performances years after.

These managers are extraordinary compensated for a single year, keep their "loot" and lose tons of money for their investors in following years.

Consequently, good many fund managers are still very well compensated by loosing a lot of money for their investors in a long-run.

2008 Apr 07 01:21 AM

[Rhodomontade:]

"Stupid rubes! It's their own damn fault if they got bilked by the carnies!"

You have the repugnant morality of a thief and the relevance of a carnival barker.

2008 Apr 07 04:01 AM