The Great Hedge Fund Mystery?
This is the time of year when publications that cover the hedge-fund industry do their annual rankings, and people get irate about the vast sums of money that the top hedgies make—in some cases, billions of dollars. At the top of this year’s list, according to a survey from Institutional Investor Alpha, are four familiar names: David Tepper, of Appaloosa Management, who made $3.5 billion; Stephen Cohen, of SAC Capital ($2.4 billion); John Paulson, of Paulson & Co. ($2.3 billion); and James Simons, of Renaissance Technologies ($2.2 billion).How do they do it? The answer is that big hedge funds are great at marketing themselves. They know how to talk up their game, they're on the recommended list of all those useless investment consultants touting them to dumb public pension funds and they have big backing from their prime brokers who also love talking up the new asset allocation tipping point because it generates more fees for them.
Questions can be raised about these and similar figures from other publications, which are rough guesstimates based on the size of the funds and the returns they made last year. The hedge-fund industry is famously secretive. Folks like Tepper and Paulson don’t take ads out in the Times or the Wall Street Journal announcing that another ten figures has been added to their net worth. But let’s assume, for now, that the numbers are broadly accurate, at least in terms of magnitude. Nobody, not even the paid defenders of hedge funds, contests the fact that some of them generate gargantuan profits for their owners and managers.
Now and then, this stirs up moral outrage. Last week, Vox’s Matt Yglesias pointed out that the $21.1 billion accumulated by the top twenty-five hedgies in 2013 was more than the combined salaries of all the kindergarten teachers in the country. Paul Krugman picked up on that fact and called for higher taxes on the hedgies, who benefit from the scandalous “carried-interest” deduction, a drum that I and many others have been banging for years.
I’ll believe that Washington is getting serious about rising inequality the day it consigns the carried-interest deduction to history. But my point here is different, and it receives rather less attention: How the heck do these guys make so much money, year in and year out? A big part of the answer is the hefty fees they charge. To put it a bit more technically: Why do investors in hedge funds—the people whose money is at risk—continue to allow the managers of the funds to dictate such onerous terms to them?
Years ago, defenders of hedge funds argued that they earned their money by delivering above-market returns on a consistent basis, but this argument is much harder to make these days. For five years in a row, hedge-fund returns have trailed the stock market. Last year was a real doozy for the industry. The S. & P. 500 had a great year and generated a thirty-two-per-cent return. According to Bloomberg, the typical hedge-fund return (net after fees) was 7.4 per cent. That’s a differential of almost twenty-five percentage points.
Not to belabor the point, but investors in hedge funds paid through the nose for this underperformance. You can invest in an S. & P. 500 index fund through Fidelity (or any large brokerage firm) for an annual management fee of about 0.1 per cent. For every $100,000 you invest, you pay $100. If you invest in a well-known hedge fund, you will probably be asked to pay a management fee of about $2,000 for every $100,000 you invest, plus a “performance fee” of twenty per cent. This is the industry’s standard “two-and-twenty” formula.
Of course, the hedgies at the top of the rankings did considerably better than the average fund. But even they didn’t beat the broader market by very much. Again, we don’t have the figures, so we have to rely on published estimates. Appaloosa’s flagship funds reportedly gained forty-two per cent. One of Paulson’s funds gained more than sixty per cent, but the firm also runs funds that didn’t do as well. Those were the top performers. In many other cases, hedge-fund managers were paid hundreds of millions of dollars even as they failed to beat the market by a considerable margin. Because of their hefty management fees and the fact that they have billions of dollars of investments under management, some hedgies can make handsome returns even when they are generating what is known in the industry as “negative alpha.”
Does this really matter? Decades ago, investors in hedge funds were almost all very rich people. If they were willing to pay two and twenty for the privilege of boasting that George Soros or Paul Tudor Jones was managing their money, it didn’t matter to the rest of us. These days, though, institutional investors, such as pension funds, charitable endowments, and even government investment funds, are big investors in hedge funds. To some extent, at least, the hedgies, with their exorbitant fees, are pocketing money that could be going to teachers, firefighters, and ordinary taxpayers.
So how do they get away with it? In carrying out their normal business, institutional investors are eager to get a break on the fees they pay to firms that manage their money. That helps to explain the rise of index funds and exchange-traded funds, which are much cheaper than actively managed mutual funds. (Index funds purchase all the stocks in a given index. Actively managed funds try to beat the market by selecting various individual stocks.) Last year, the California Public Employees Retirement System, known as CalPERS, announced that it was switching more and more of its assets to index funds and other passive investments. In the United Kingdom, the government has just announced that almost half of all the assets controlled by local authority pension funds will be switched to index funds in order to save cash.
How has the hedge-fund industry escaped this cost-cutting trend? Part of the answer is that it hasn’t, or not entirely. Institutional investors are forcing some hedge funds, particularly the newer ones, to back off the old two-and-twenty formula. Earlier this year, citing figures from Hedge Fund Research, a firm that tracks the industry, The Economist said, “Investors have succeeded in amending the formula to something more like ‘1.4 and 17,’ at least for newcomers to the business.”
And yet, the biggest and most successful funds have been largely immune to this austerity drive. Some them charge even more than two and twenty (SAC, before the government effectively closed it down for being a hotbed of insider dealing, was reputed to charge three and fifty). And, of course, a fee structure of 1.4 and seventeen is still very generous to the hedgies. If, last year, I ran a hedge fund with five billion dollars under management, had charged those fees, and had merely matched the stock market, I would have made more than four hundred million dollars.
Even after deducting the considerable costs of a running a big hedge fund, that’s serious moolah. So, again: How on earth do they get away with it? It’s a competitive industry, and there’s no obvious reason why the normal laws of economics shouldn’t apply. Competition and entry should drive down prices. At the very least, you would think that there would be a movement to change the performance fees so they are assessed relative to the market return, rather than relative to zero. But it hasn’t happened, and the question is: Why not?
Answers on a postcard, please. And note: saying that investors are willing to pay for performance won’t do. That’s begging the question rather than answering it.
I am amazed at just how dumb and lazy institutional investors have become. Such a herd mentality piling into all the brand name funds, getting raped on fees. Those fees, especially that management fee, are paid out no matter how poorly the hedge fund performs. No wonder the hedge fund gurus are making astronomical amounts and are all way overpaid. They have succeeded in hoodwinking the pension fund industry into believing all sorts of garbage.
But some large public pension funds have had enough and are now chopping their hedge fund allocation. If you ask me, there is a crisis of confidence going on and I think the alternatives gig is up. It's not just hedge funds. Investors are tired of paying huge fees and getting shitty performance. That is one reason why CalPERS and others are rediscovering the joy of indexing their portfolio. Why pay some arrogant hedge fund or private equity manager 2 & 20 for sub-beta performance? It's insane!
And yet, hedge funds are not dead. The institutional love affair with hedge funds continues unabated. Investment consultants are getting in on the game, which typically spells trouble, and despite hedge funds having suffered the worst performance start to the year since 2011, industry assets hit a new peak of $2.7 trillion thanks to healthy net inflows. And who is leading the charge? Who else? Dumb public pension funds getting raped on fees, ignoring the hedge fund curse.
I've said it before and I'll say it again, if the ILPA had any clout, it would muscle hedge fund fees drastically lower. Some wise hedge funds managing billions in highly liquid strategies are already chopping fees in half. I'm still waiting for the day when someone will write a big check to Ray Dalio's Bridgewater and tell them they are only paying performance fees, no management fees.
In fact, I openly challenge Bridgewater, Blackstone, and many other alternative investment shops managing billions to go to their investors and say that from now on they will only charge performance fees and there will be a hurdle rate of T-bills + 5% (PE funds already use a hurdle before charging performance fees). That's what I call real alignment of interests.
But don't hold your breath, no hedge fund or private equity fund will ever have the balls to accept my challenge. They're raking it in as pension funds bet big on alternatives. It's the biggest joke in the world. There will always be some sucker paying the perfect hedge fund predator 3 & 50 so they can boast to their friends that they're invested with Stevie Cohen. Honestly, the entire industry is a joke, which is why I love poking fun at how dumb pensions are getting bamboozled by slick hedge funds.
In 2005, Tom Barrack, the king of real estate, cashed out right before the financial crisis, and stated flat out: "There's too much money chasing too few good deals, with too much debt and too few brains." The amateurs are going to get trampled, he explained, taking seasoned horsemen, who should get off the turf, down with them. He was bang on.
I remember circulating that article to PSP Investments' senior managers. It drove André Collin nuts but he got out of PSP with millions in bonus trouncing his bogus benchmark and joined Lone Star funds where he's now the head of global operations. Quite a scandal that was never mentioned in the Auditor General's Special Examination of PSP.
Of course, when it comes to real estate, I trust Tom Barrack a lot more than André Collin. I think Barrack's famous quote is even more true now than in 2005. Never in the history of pension funds has so much money with so few brains been piling into alternative investments praying for a miracle.
But there will be no miracles. The only thing going on is a bunch of rich hedge fund and private equity managers are getting even richer while pension deficits grow wider and wider. Unions are asleep and so are the fiduciaries of these public pension funds getting raped on fees. I can't repeat it often enough, the biggest problem plaguing pensions is lack of proper governance. Until they get the governance right, all other reforms on pensions are cosmetic and will do nothing to tackle the public pension problem.
Now, before I get some arrogant hedge fund manager sending me an angry email telling me how hedge funds have "skin in the game" and how they align interests with investors better than mutual funds, save it. I know all the arguments for and against hedge funds and I remain as cynical as ever.
Importantly, when you're collecting billions in management fees for turning on the lights, you're a frigging overpaid joke and I will call all of you so-called gurus out for what you are, overpaid marketing geniuses.
The only mystery is why are dumb public pension funds continuing to enrich Wall Street and a bunch of overpaid alternatives gurus? The answer is that the entire system is defunct and serves no purpose whatsoever but to enrich the real wolves of Wall Street who literally have a license to steal billions.
There might be another reason as to why big hedge funds are growing bigger, enriching their overpaid managers even if they underperform, one embedded deep in the psyche of institutional investors who secretly suffer from penis envy. Therefore, I leave all you 'big swinging dicks' in finance with a documentary which discusses the mystery of big penises. It might help you understand the great hedge fund mystery.
I'm not kidding, you could learn a lot from watching the documentary below.Why? Because any guy who would surgically implant fat cells in his penis needs to get his head examined. And any pension fund that needs to be invested in the "biggest" hedge funds no matter what the fees and performance needs a reality check. When it comes to penises and hedge funds, bigger isn't always better!