Is Everything That Didn’t Work Worthless? Part II

In my last post, we discussed the sorry state of value investing following seven years of rigged markets courtesy of our central bankers. In this post we’ll turn to another category of investing that sits right near the top of so many investors’ Sh*t Lists: hedge funds.

Whole books have been written about hedge funds, and I myself have dedicated thousands of words to the subject in my books, white papers and blog posts. But today I’m approaching the subject from a slightly different perspective: the difficult investment environment faced by hedge fund managers—and virtually every other investment category—in the face of unconventional Federal Reserve policies.

Specifically, I’ll limit myself to three of the more central issues affecting hedge funds: fees, performance, and what I’ll call investor misunderstanding of the role hedge funds play in their investment portfolios.

Fees

Few issues raise investors’ hackles more than the very high fees charged by hedge fund managers. These fees are typically known as “2 & 20,” that is, a 2% annual management fee plus 20% of any profits, sometimes over a (not very high) hurdle rate. Actually, pressure on fees in the hedge industry has already reduced the typical fee slightly, so it would now be more accurate to call it “1½ & 20.” However, “2 & 20” has a nicer ring to it, so we’ll stick with that.

A recent column in the Wall Street Journal was typical in promoting outrage. The column pointed out that Bill Ackman’s closed-end fund (not his better-known hedge fund) had returned a total of only 20.5% over the past four years while the S&P was producing 67%. Meanwhile, the closed-end fund kept 72% of its gains, leaving investors with only 28%.

But before your blood starts to boil over and scald your eyeballs, keep in mind that a four-year period during which the Fed was rigging markets is a flat-out silly time over which to judge a manager’s results or fees. Consider, more appropriately, that Ackman’s flagship fund, Pershing Square LP, has produced since its inception in 2004 annual compound returns of 14.9%, compared to a measly 7.6% for the S&P. Anyone who wouldn’t pay 1½ & 20 (which is what Pershing charges) for extraordinary performance like that is being pennywise and pound-foolish.

The best response to complaints about hedge fund fees is this one: it’s a free country, pal, and hedge funds don’t charge any more than what the market will bear. Nobody is putting a gun to anybody’s head and forcing them to pay 2 & 20—or, for that matter, to pay the obscene price of a BMW i8. We are all perfectly free to invest with Vanguard or to drive Chevys.

At last count, $2.8 trillion was invested in hedge funds at average fees of 1½ & 20, and it seems unlikely that all that money is stupid. It’s certainly true that some big name pension funds have recently reduced or even eliminated hedge fund exposure, but this is the exception that proves the rule: these funds (I’m not naming names but you know who they are) tend to be poorly governed, largely brain-dead, fraud-prone institutions, many of which had such de minimis exposures to hedge that the allocation didn’t justify the (very significant) diligence required. When we start to see Yale, Princeton and Notre Dame dumping hedge funds, it might get our attention.

Unfortunately, the free-market excuse for hedge fund fees isn’t the whole story, for a couple of reasons. First (I’m jumping ahead a bit here), there is the question of what-you-pay-for-what-you-get. In the long-only world the average manager underperforms gross of its fees. When you deduct fees, the underperformance gets much worse. But things are different in the hedge fund world. Because of the talent drain from long-only to hedge, and because hedge managers have many more tools at their disposal, the average hedge fund manager outperforms gross of fees. Unfortunately, fees are so high that the average hedge fund underperforms on a net-of-fee basis. If fees could be reduced to the point where the average hedge fund outperforms both gross and net, much of the criticism around fees would disappear.

The second reason the free-market excuse for hedge fund fees isn’t totally convincing is that the hedge fund industry itself recognizes that manager and investor interests could be much better aligned. In other words, it’s not just that fees are high, it’s also that under certain circumstances managers can prosper even as investors suffer. Consider the example mentioned above, where the Pershing Square closed-end fund rewarded itself at its investors’ expense. That happened because good early performance was followed by poor later performance. During the periods of good performance, Pershing got its annual management fee and 20% of the profits. But when bad performance arrived, the fund’s investors gave up their earlier returns while Pershing kept its earlier carry, which had already been paid out.

So why doesn’t the industry lower its fees and restructure the carry to better align managers and investors? There are 2.8 trillion reasons why—that massive installed base of hedge fund client capital isn’t going to get lower or better-structured fees because it has already accepted the going rate. New hedge funds could experiment with different fee structures, but that isn’t much happening because there are only two kinds of new funds: those started by people with terrific pedigrees and track records who can and will charge what the market will bear, and those started by everybody else who aren’t a bargain under any circumstances.

Given the fees now charged by hedge funds, the average hedge fund is a very bad investment idea. But just as the Golden State Warriors don’t draft average basketball players, the best firms (the better endowments and wealth management firms, for example) don’t work with average hedge funds. The best firms expect to add roughly 3% per annum above the hedge fund averages over time, and it’s that increment of value that justifies 2 & 20.

Next: Is Everything that Didn’t Work Worthless? Part III