Wednesday, August 19, 2009

Hedge Funds Reexamined

Hedge funds have taken a lot of criticism over the last 2 years for pumping up markets and/or leveraging their capital to make big momentum bets. Naturally when the markets corrected, which took a lot of hedge funds down with it, many of the critics were rubbing their hands with glee - sometimes, we just love to see tall poppies being hacked, or misery happen to the rich and successful ... Hedge funds took the blame for much of last year's financial havoc, but the fact is that they have played a much more benign role than is commonly thought.

Plenty of funds went under with the market plunge: a record 1,471 in 2008 out of a total of 6,845, according to the Chicago tracking firm Hedge Fund Research. But the government didn't bail out a single one. That's the way capitalism is supposed to work: incompetents go out of business, smart guys clean up. How about that, hedge funds NEVER GOT ONE CENT from any government. You fail, you close shop. you lose money, you take it on the chin and walk away to do something else.

The hedge-fund industry has shown remarkable resiliency, turning in a gain of more than 12 percent for the first seven months of 2009. The firms that caused most of the trouble on Wall Street were not hedge funds but big investment banks and insurance companies trying to act like hedge funds. They did a lot of risky proprietary trading with other people's money, and they failed. The key is betting using "other people's money" or your own capital. Funnily, firms that bet using their own capital have generally performed a lot, lot, lot better. This is the one big lesson all regulators, investors and senior management need to know by now.

Wall Street's most successful long-term model has been companies like Brown Brothers Harriman or Goldman Sachs, where firms bet the owners' own capital. Such a structure ensures careful risk assessment. Similarly, many hedge-fund managers have a lot of net worth invested in their own funds. Former Fed chairman Paul Volcker has proposed that federally insured banks be barred from proprietary trading. Maybe only hedge funds have earned the right to be the big risk takers of the future.

While many will continue to sneer and hope that more hedge funds will find troubled waters in the future ... much of it is envy and the inability to accept their compensation schemes. Most hedge funds charge an annual 1%-2% fee, plus a 20% cut of any positive returns. Some funds may have a minimum hurdle return rate (e.g. 5%) before the 20% share kicks in. All you need is a couple of good years before one can retire comfortably. Say a team of 3 runs a US$100m hedge fund. They have US$1.5m in fees to cover costs. If their fund gets a return of 18% for the year, technically they will get US$3.6m in performance profit share. You can do the math if one person manages US$100m or more. You can also do the math if you can leverage that capital 100% and double your return to 36%, thus doubling your profit share to US$7.2m. In a good run, not many investors will care about the leverage or risk that you took to get the returns as long as they were spectacular. In a down market, only then will investors and fund of funds start asking hard questions about leverage, reporting frequency, the ability to take money out at regular intervals without penalty, the amount a fund pays in commission, the percentage of portfolio that was turned over in a year, the alpha and beta and the gamma (no, we are not talking about radioactive rays).

My view is that hedge funds are here to stay. I would want to pay somebody a 20% bonus if they make me more money. I am sure the managers' interest is aligned with mine. What an investor has to be careful is that the compensation structure encourages big bets. The structure also encourages to bet aggressively to notch super normal returns as losses are not the end of the world - many dubious players will close the funds when they have one or two years of negative returns (you would then have to make up the deficit before getting the 20% profit share again)... only to reemerge somewhere else again with a new fund and new partners. Thus investing in hedge funds mean you have to know a bit about the people running the funds. You also have to know their strategy and leverage, and if you are rich enough to invest in hedge funds, spread it among a few funds, with differing investing strategies, and a decent track record.

There are many who will be starting afresh hedge funds, calling for subscribers. They are not as dangerous as one might think. They offer a fresh start, always judge them on what they had done before and what they want to achieve. New funds are more agreeable with "anytime withdrawals" and lower fees. Bear in mind that there is a danger when funds get too big. It gets that much harder to perform when its starts getting close to the US1bn mark, unless the hedge funds is based solely on quant models and program trades.

p/s photos: Chrissie Chau


solomon said...

Given a choice, what is the typical fund size you prefer to run? What is the return you think you could provide?

Maybe we could be your partner one day. My fund is notching NAV 13 in Marketocracy since I started.

We shall compare at year end, dud.

JL said...

Dear Salvatore, with what basic knowledge that I have on hedge funds and fund management in general, I agree with you on the notion that it is the survival of the fittest out there. But what would your opinion be of a company that thrives to be the fittest by being the biggest ie KKR? Since there is a statement that say a company is too big to fail, can a company be too big to succeed?