Editore"s Note
Tilting at Windmills

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April 24, 2007
By: Kevin Drum

HEDGE FUNDS....I really don't get hedge funds. Their reported performance is only a bit higher than most stock market indexes, and there's very persuasive evidence that even the reported performance is overstated — possibly by a lot. So why are people willing to pay fees of 20% or more to hedge fund managers? What am I missing?

Take this story in the New York Times, for example. The top hedge fund manager in the world posted a gross return of 84% last year using rocket science algorithms of various kinds, so it's easy to understand why his customers were happy to pay him astronomical fees. But there's also this:

Raymond T. Dalio, head of Bridgewater Associates, which has more than $30 billion in hedge fund assets, for example, took home $350 million last year even though his flagship Pure Alpha Strategy fund posted a net return of just 3.4 percent for the second consecutive year.

Why would anyone in their right mind keep their money in this fund? More to the point, how has Dalio avoided angry mobs of customers threatening to do things that even John Yoo wouldn't approve of unless he gives back a piece of that $350 million? ($350 millon!)

Beats me. But at least I'm not the only one who's confused:

"There is some question as to what the hell they are doing that is worth" that kind of money, said J. Bradford DeLong, an economist at the University of California, Berkeley. "The answer is damned mysterious."

Anyone care to enlighten us?

Kevin Drum 1:22 AM Permalink | Trackbacks | Comments (58)

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Comments

Every minute, another Al is born.

Posted by: none on April 24, 2007 at 1:47 AM | PERMALINK

Anyone care to enlighten us?

Nothing illegal.

Posted by: Old Hat on April 24, 2007 at 1:50 AM | PERMALINK

It mystifies me, too. Considering the leverage used in some of these rocket-science hedge-fund trading strategies, we may see one or more blow up as the economy turns south.

Posted by: troglodyte on April 24, 2007 at 1:51 AM | PERMALINK

Considering the leverage used in some of these rocket-science hedge-fund trading strategies, we may see one or more blow up as the economy turns south.

Long Term Capital Management 2: Recession Bugaloo

Posted by: Old Hat on April 24, 2007 at 1:53 AM | PERMALINK

Well... It's hard work to get 84% returns; harder still the more money you put in: Your very money starts moving the market. The idea behind hedge funds is that they're split out from other monies, and move through the markets seperately.

But...

...I could open a savings account and have 4%, so I have no idea why this guy was worth it.

Then again, how much is the CEO of my bank getting?

Posted by: Crissa on April 24, 2007 at 1:54 AM | PERMALINK

hehehe....

mms://media2.bloomberg.com/cache/vvefEajX3Khs.asf

Be patient. It's twelve minutes long, but there's much info about the status of hedge funds. You can start @ 7:45 for hedge funds, if you are not interested in the real estate market.

Posted by: Anonymous on April 24, 2007 at 2:06 AM | PERMALINK

Well, there are a lot of overpaid CEOs, Crissa is right that many banks probably have one. But isn't $350m pretty spectacular in absolute terms? Does anybody else get that much???

But good lord, that is 1.17% of assets! 34% of profits! Why don't these rich fools just drop their money in Vanguard and mail the dividends to this guy's yacht dealer?

It's just the sex appeal of saying you are in a hedge fund. Just cause they are rich, does not mean they are smart.

Posted by: BoulderDuck on April 24, 2007 at 2:22 AM | PERMALINK

The answer is simple: it's the same reason why people pay 5.75% front-end loads and 2.00% expense ratios for mutual funds when they could be paying 0.00% loads and 0.20% expense ratios for better performing index funds at Vanguard (a customer-owned cooperative). Rich people are no smarter with their money than everybody else.

Posted by: Chris on April 24, 2007 at 2:30 AM | PERMALINK

This is the best thing ever written on hedge funds:

http://www.econbrowser.com/archives/2005/11/hedge_fund_risk.html

Posted by: chris on April 24, 2007 at 2:32 AM | PERMALINK

So why are people willing to pay fees of 20% or more to hedge fund managers? What am I missing?

That's 20% of the profits, if there are profits. Investors gamble that hedge fund managers can preserve capital (not always true) while occasionally bringing in astronomical returns.

The high compensation can be understood from the following:

1. There is a lot of money to be invested (not only by the super-wealthy, but also by large institutions like pension funds).

2. Even if only a small portion of the total capital available goes to high-risk investments like hedge funds, that portion is still huge.

3. There is a lot of concentration of this invested capital in the hands of the "best" money managers. These are the guys that make the huge sums -- because even if they take 20% of a 5% profit from a capital of $100 billion, that's $1 billion. 40% on a 10% profit is $4 billion. etc -- it goes up very quickly.

The markets being what they are, when one manager has a couple of good years in a row he/she becomes "hot" -- and their cut goes up at the same time as their fund attracts more capital.

Hedge fund returns have not been as good recently as they had been in earlier years, but many investors seem to be expecting that better days will return, as they often do in the markets.

Posted by: JS on April 24, 2007 at 2:39 AM | PERMALINK

Awesome!

An angry liberal blogger ™ was quoted in the NYT!

I had better shield my fetus' eyes lest he see the vulgarity...

Posted by: hello on April 24, 2007 at 2:49 AM | PERMALINK

Part of what hedge funds are supposed to offer is not only greater returns, but lower volatility of those returns. Alternatively, you could also earn those fees by offering market comparable returns with lower volatility, making it a more valuable product. The problem is that in order to generate greater returns, a lot of managers are engaging in more risky assets, more leverage, which typically result in greater volatility and therefore, risk. So its not clear whether the product is still offering the favorable risk/return proposition it previously provided.

Posted by: Jeep on April 24, 2007 at 3:03 AM | PERMALINK

Conventional institutional fund management has been 'commoditised'. It turns out that what a lot of the active managers were doing was tracking the index, taking very little risk against the benchmark.

Clients were paying active fees (typically 70-100 basis points ie 0.7-1% pa) for passive performance (typically sub 10 basis points for a passive fund).

(see Fidelity Magellan for a version of this in the retail mutual fund world)

So the trustees called time on this strategy, and more and more institutional money is now indexed.

The problem is, returns have fallen. The historic return of stocks is something like 12% per annum, the expected future return is closer to 8%.

To meet the needs of plan sponsors, institutions have sought out managers who appear to have 'hot hands' and can generate well above market performance (hedge funds). Since most of the hot hands now work for hedge funds, that is where the money is going.

(other 'alternative' asset classes like private equity, commodities, real estate etc. are also booming)

The brutal bear market of the early '00s has also had its role. Equity portfolios halved in value, whereas many hedge funds did far better (that's kind of the point, of being a 'market neutral' hedge fund-- market neutral is no longer the most common kind of fund).

High Net Worth Individuals are very averse to losing capital. So they have always been a fan of asset products that have lower volatility of capital value (like real estate or hedge funds). Institutions have now jumped on the bandwagon.

What HFs offer is (theoretically) returns which are uncorrelated with the stock market (thus granting a 'free win' in finance theory: diversification means the same return for lower risk), and superior returns.

In practice, most HF categories are now so competitive, that HFs are reaching for higher and higher levels of risk to eek out returns. And 'leveraged long' is the strategy of the day ie if the market goes down, there is the potential for the HF to go down *more*.

As many HFs are disappearing, as are being created. The winners collect *all* the money, until they stumble. There is performance chasing highly reminiscent of the 'hot' mutual funds of the late 90s.

Right now there is a lemming-like rush into alternative assets by institutions, and I expect the really shrewd alternatives players, like Yale Endowment (arguably the best managed portfolio in America, if not the world-- and certainly the best managed large portfolio for which there is public data) will actually make more investments in garden variety large cap US equity.

When Hedge Fund managers begin to list their management companies, ie the golden asset that *collects* these fees, you are probably calling the top of the cycle. And indeed, people like Fortress (?) and Blackstone have listed their management companies. Since a HF management company has no need of capital (it's basically people + desks + computers), listing is simply a way to capitalise on the value created for the owners. Or as someone wisely put it in poker: 'if you can't figure out who the mug is, then you are the mug'.

Posted by: Valuethinker on April 24, 2007 at 3:13 AM | PERMALINK

Are they worth it? Of course! The rich deserve every bit of our money that they have coming...even if they have to take it from other rich people.

Silly silly Kevin.

Posted by: TomStewart on April 24, 2007 at 4:58 AM | PERMALINK

Let me see. A former trader on Enron's energy desk is making unbelievably large returns and is unwilling to tell anyone how.

I am utterly convinced that everything is above board here.

Posted by: ajay on April 24, 2007 at 5:49 AM | PERMALINK

Let's see . ..
John Law
Mr. Merdle
Tulips

The same old story, with new characters.
See also Confidence Man, The by H. Melville

Posted by: Steve Paradis on April 24, 2007 at 6:42 AM | PERMALINK

It cannot be that DeLong does not know about tulips...get him to tell you about them and The Madness of Crowds.

Posted by: JF Shepard on April 24, 2007 at 7:33 AM | PERMALINK

"So why are people willing to pay fees of 20% or more to hedge fund managers? What am I missing?"

Conservative mythology. Hedge funds are less regulated so they must be, you know, better - whether or not there is any proof to that effect.

Posted by: Fred on April 24, 2007 at 7:49 AM | PERMALINK

It must be related to why folks don't object to ever lowering taxes on the super rich; they assume that as Americans they will eventually be in that class and benefit from low taxation. And so, they do not begrudge their fund manager becoming super rich at their expense.

Posted by: Rula Lenska on April 24, 2007 at 7:51 AM | PERMALINK

Hedge funds are permitted to invest in any thing they want to and the investors give these guys their money to potentially gain higher returns. The real benefit is investing in private cos., start-ups and particularly distressed cos.
One aspect of the market is that banks can't carry NPAs for long because of both the regulators (OCC, Fed and sometimes,state) and the stock market. the banks are, in essence forced to sell NPAs and these funds are among the buyers. (Cerberus Partners for example has grown to the point where it was the lead in buying 51% of GMAC; 15 years ago, they didn't exist).

This is one part of the disclosure for hedge funds:
# A Hedge Fund’s fees and expenses-which may be substantial regardless of any positive return- will offset the Hedge Fund’s trading profits. In a fund of funds or similar structure, fees are generally charged at the fund as well as the sub-fund levels; therefore fees charged investors will be higher that those charged if the investor invested directly in the sub-fund(s).
# Hedge Funds are not required to provide periodic pricing or valuation information to investors.
# Hedge Funds and their managers/advisors may be subject to various conflicts of interest.

Posted by: TJM on April 24, 2007 at 8:05 AM | PERMALINK

Bogle used to say: there are plenty of people who will beat my index funds over 10 years. Say 25% of the active managers out there. The problem is, there is NO WAY to know /in advance/ who those 25% will be. And the other 75% will lose against the index funds - some of them very badly.

Would you put your money in a slot machine with odds of 75:25 against you? That is basically what the current generation of hedge fund investors is doing, seduced by those huge returns to /some/ of the first movers. And the hedge fund managers are gladly fleecing the sheep. As they have since ancient Egypt at least.

Cranky

Posted by: Cranky Observer on April 24, 2007 at 8:14 AM | PERMALINK

Why would anyone in their right mind keep their money in this fund?

There is a word for it: Kickbacks. First, there is no retail business here, just big retirement and investments funds, managed by fiduciaries. When these fiduciaries are being courted by the hedge funds they are wined and dined very nicely, thank you.

When the hedge fund is taking 20% in an rising market, even 1% going back to the fiduciaries in kickbacks is a LOT of moolah, enough to corrupt nearly anyone on Wall Street.

Posted by: Xenos on April 24, 2007 at 8:18 AM | PERMALINK

Do you suppose that there might also be a prestige element to hedge-fund participation? I am not an economist or finanical-sector analyst, but it seems that among the elite and insular set of wealthy New Yorkers or Bostonians or whatever, hedge fund investment would serve as a powerful signifier of one's place in the club, both socially (access to hedge funds is limited) and of course monetarily (many hedge funds, at least insofar as I understand them, have relatively pricy floors for even limited participation.)

While many rich people are surely exceedingly rational with their investments, there must be a number of them who also want collateral social benefits from their investments, hence the potentially-mysterious obsession with hedge funds. Maybe a similar case would be buying a house in Aspen or Vail as a real estate investment, even the market was hotter and the profits margins were better for houses in Bemidji or Dubuque or Yuma, Az.?

Posted by: Matt on April 24, 2007 at 8:30 AM | PERMALINK

I've never heard of a hedge fund charging a 20% management fee. The usual fee structure in the hedge fund world consists of a 2% management fee plus an "incentive fee" of 20% of the fund's profits -- this is commonly referred to as the "2 and 20" fee structure.

Why do wealthy individuals and institutional investors invest in hedge funds? One of the reasons is that they want to allocate some of their capital to/ invest some of their portfolio in investments that are uncorrelated to the broad markets, i.e., that don't just rise and fall in tandem with the broad markets.

What do hedge fund investors think they are buying? The buzzword is "alpha," i.e., returns that are attributable to management skill, as opposed to "Beta," i.e. returns associated with the broad market.

This isn't so different from why investors buy bonds. After all, equities have historically outperformed bonds -- so why does anyone buy bonds? Why don't people just put all of their money in stocks? The answer is that people don't think it makes sense to put all of their eggs in the same basket -- they seek to diversify the risks that they are exposed to.

Posted by: Eric on April 24, 2007 at 8:31 AM | PERMALINK

Hedge funds used to fill a niche in the market because they had access to the entire spread of financial instruments and weren't limited by their charters to any particular behavior. (Mutual funds having to be invested in the market even when they knew keeping capital in cash was better at that point in the cycle, for instance.) In other words, hedge funds used to be getting their profits on arbitrage--profiting from inefficiencies in the market. (And yes, survivor bias did enter into the aggregated statistics.)

There are now more and more mutual funds out there available for the general public which use the same investing strategies that hedge funds do, thus the potential for arbitrage has gone down as well as the generated returns.

"good practices" of hedge funds (no more 250: 1 leverage like LTCM) has kept a lid on the leverage multiples, although it may be moving up again.

Posted by: grumpy realist on April 24, 2007 at 8:35 AM | PERMALINK

Ponzi schemes dressed up in a lot of razzle-dazzle are still Ponzi schemes. It's all smoke and mirrors predicated on spinning vast oceans of debt in exchange for someone else's real assets.

Perhaps it should really be termed the Rapunzel Economy.

Got tulips?

'Another bubble has emerged in hedge funds and private-equity funds, which have so much money they're buying up whatever they see. When these bubbles burst, it will be time to run for cover. The noise will be loud enough to shake foundations from New York to San Francisco.' - ROBERT REICH, 'If you invest in stocks, don't look Dow-n'
http://www.nydailynews.com/news/ideas_opinions/story/
501514p-422920c.html

'When you are talking about fiat money, let’s face it… money is only worth what you can barter for it. It is interesting to note that the recent jump in the dollar price for a barrel of crude is almost completely explainable by the erosion in value of the dollar relative to the POUND or the EURO.

[snip]

In calendar 2007 US/us is right on target for buying some $ 800 BILLION more of foreign made “stuff” than we are selling of our own products to the rest of the world. That breaks down to a “net” outflow of newly printed bucks to the tune of almost $ 2.2 BILLION per day!
Fred Cederholm
Just WHO is Buying America? And... With What?
http://www.smirkingchimp.com/thread/7001

Posted by: MsNThrope on April 24, 2007 at 8:41 AM | PERMALINK

A fool and his money are lucky to get together in the first place.

Posted by: Monkey on April 24, 2007 at 8:43 AM | PERMALINK

"Doug Noland over at Prudent Bear.com is right: we've entered a euphoric phase of financial arbitrage capitalism with extreme Ponzi overtones, a pyramid scheme of revolving credit rackets and percentage spread plays completely abstracted from any reality of fruitful activity. The reason we don't even call "money" by its former name anymore is precisely because we realize at some semi-conscious level that "liquidity" is not really money. Liquidity is a flow of hallucinated surplus wealth. As long as it flows in one direction, into financial markets, valve-keepers along the pipeline, like Goldman Sachs, Citibank, or the hedge funds, can siphon off billions of buckets of liquidity. The trouble will come when the flow stops -- or reverses! That will be the point where we will rediscover that liquidity really is different from money, and if we are really unlucky we'll discover that our money (the US dollar) is actually different from real wealth."

http://jameshowardkunstler.typepad.com/
clusterfuck_nation/

Italics mine.

'Mr. [Chairman of the House Financial Services Committee Barney] Frank said that one potential concern was the large amount of debt that hedge funds use to amplify the size of their bets, a technique known as leverage. Using leverage, hedge funds have magnified the reach of their already considerable assets, which have reached more than $1 trillion worldwide according to some estimates.

“Theoretically, they have more money than there is money,” Mr. Frank said.

One question is whether, if many of these highly leveraged bets go bad, it could create instability in the global markets, causing what Mr. Frank described as “a run on the world, not just a run on the bank.” '
Frank Talk on Hedge Funds
http://dealbook.blogs.nytimes.com/2007/02/21/
frank-talk-on-hedge-funds/

I'd say 'any' not 'many'. Couple of Amaranths [$6B in vanishes in 5 days] and poof.

Posted by: MsNThrope on April 24, 2007 at 8:55 AM | PERMALINK

Well, that saves me from sending a hedge fund thread alert to the land of Magnolias.

Posted by: thethirdPaul on April 24, 2007 at 9:22 AM | PERMALINK

It's not actually complicated. Can you spell "Ponzi"?

Con artists can sell ice to Eskimos.

Posted by: zak822 on April 24, 2007 at 9:27 AM | PERMALINK

Amaranth isn't a good example since the gains that allowed the fund to bet so heavily on the spread between natural gas prices and oil (the calendar effect) weren't real in the first place. The fund didn't distribute much of the initial gains, they were paper, too. The $6B loss ate into the original capital which meant he couldn't leverage his way back into any position that might make him whole (and it was a single guy doing all the trades).
As it turned out, he was the market, there were no offsetting trades. His illusory gains were from his creating the appearance of liquidity in the market which he could never turn into cash. He was both sides of the trades.

Posted by: TJM on April 24, 2007 at 9:27 AM | PERMALINK

It is instructive that one fee only financial advisor, Frank Armstrong, has said that if he put any of his clients' money in a hedge fund his insurance carrier would cancel his errors and omissions coverage. He compares hedge funds to the limited partnerships crraze of the 1980s. Says Armstrong of LPs: "Becoming a member of this sophisticated club of knowledgeable investors distinguished you from the chumps who were not offered admission. Does any of this sound familiar?"

Posted by: JHM on April 24, 2007 at 9:28 AM | PERMALINK

PrundentBear.com is an excellent place to put a bunch of these threads together.

We have this from The Economist

[snip]

'People tend to think of two types of money: narrow money (notes and coins) and broad money (bank accounts and other kinds of assets). Mr Roche says this structure is like an inverted pyramid, where the top layer is derivatives, worth more than nine times global GDP. Credit derivatives are only a small part of this, but already the amounts involved are staggering. According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year. With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion (see chart).

This derivatives “money” is not being used to buy food, clothes or cars—which is why there has been no general pick-up in inflation. But it has been used to inflate asset prices, Mr Roche argues.

The danger is things might go into reverse. A rising cost of capital (perhaps from inflation worries) or a rise in risk aversion (due to a pick-up in defaults) might be the culprit. If liquidity falls throughout the system, derivatives will take the biggest hit. But the result, if derivatives have been pumping up the demand for assets, could be a sharp fall in asset prices.'

[snip]

Italics mine.

But do you understand what '9 times global GDP' means? It means that the next nine years of 'projected' (thus possibly at least in some greater or lesser part imaginary) global production of goods and services is already hocked (financialized and discounted) to the hilt. Taking the profits today on goods and services which might materialize 9 years out?

Ponzi must be proud.

Posted by: MsNThrope on April 24, 2007 at 9:31 AM | PERMALINK

Here's my psychological answer, Kevin:

Keeping up with the Joneses.

Posted by: SocraticGadfly on April 24, 2007 at 9:32 AM | PERMALINK

It's not the average performance, Kevin. It's the standard deviation among those performances. The top guys can earn massive amounts - far more than any mutual fund - and they can lose it as well. What's silly is that even mediocre managers still charge these types of fees.

Posted by: orion on April 24, 2007 at 9:43 AM | PERMALINK

Well, that saves me from sending a hedge fund thread alert to the land of Magnolias.
Posted by: thethirdPaul

Thanks anyway.

heh

Posted by: MsNThrope on April 24, 2007 at 9:46 AM | PERMALINK

MsNthrope, your statement "what '9 times global GDP' means? It means that the next nine years of 'projected' (thus possibly at least in some greater or lesser part imaginary) global production of goods and services is already hocked (financialized and discounted) to the hilt." isn't right. The amounts are nominal amounts. These derivatives, such as credit default swaps, are insurance that only pays in a single case. They don't represent liens on anything per se, since they only pay the actual debt involved.The question is who ends up holding that underlying debt at the end of the day. It's musical chairs where the guy who gets to sit loses. The rest just collect the fees.

Posted by: TJM on April 24, 2007 at 9:59 AM | PERMALINK

Jim Cramer is getting soooo misty eyed this morning. And the Game begins anew.

Posted by: thethirdPaul on April 24, 2007 at 10:06 AM | PERMALINK

I don't believe the market is perfectly efficient. There are people who can consistently beat the market averages. They are few and far between, however, and as cranky observed above, it is impossible to pick them out ahead of time. For every physician from Omaha who put his money with Warren Buffett in the 1960s, there were at least three physicians (and probably more), who were every bit as smart as the Nebraska M.D. who paid a ton of fees to lag the market.

People pay for hedge fund performance for the same reason they pay touts to tell them which football teams they should wager on; they hugely overestimate the ability of the alleged soothsayer.

Posted by: Will Allen on April 24, 2007 at 10:10 AM | PERMALINK

>> "what '9 times global GDP' means? It means that
>> the next nine years of 'projected' (thus possibly
>> at least in some greater or lesser part
>> imaginary) global production of goods and
>> services is already hocked (financialized and
>> discounted) to the hilt."

> isn't right. The amounts are nominal amounts.

As long as no more than some small fraction (1/81st, say) try to cash out at the same time. Or nothing serious goes wrong with the global financial system. For reference on what happens then, read a biography of Samuel Insull.

Cranky

Posted by: Cranky Observer on April 24, 2007 at 10:15 AM | PERMALINK

"There is some question as to what the hell they are doing . . . "

The official answer is that they are providing investment strategies with low or no correlation with the S&P 500 (the "hedge" in hedge fund). Adding uncorrelated assets to a portfolio can improve overall performance even when the returns on the fund are equal to or only slightly greater than the returns on the market. And because most hedge funds pursue total return or "pure alpha" strategies, in theory their returns should also be uncorrelated with each other -- further enhancing the diversification benefits.

Well, that's the theory anyway. In reality, hedge funds tend to become EXTREMELY correlated with the S&P 500 and with each other during financial panics, when the liquidity risk inherent in their trading strategies suddenly becomes obvious to all. Long Term Capital Management being the most famous example.

So, in reality, I would say that hedge funds primarily exist to give wealthy doctors and college endowment trustees something to brag about at their cocktail parties.

Posted by: Peter Principle on April 24, 2007 at 10:24 AM | PERMALINK

Bob Chapman of The International Forecaster: “US debt was up 10.1% to $4.085 trillion and accounts for 58.8% OF ALL THE CREDIT ISSUED GLOBALLY LAST YEAR. The US is producing more debt than the rest of the world combined."

Posted by: MsNThrope on April 24, 2007 at 10:44 AM | PERMALINK

Psychology, the true parent of economics.

Hedge funds sustain a mystic of insider knowledge. Let's face it, insider knowledge returns bigger rewards. It's the mystique.

Posted by: John Forde on April 24, 2007 at 10:46 AM | PERMALINK

If you have money in a hedge fund it means you are really rich. Which, when you think about it, is reason enough to get involved.

Right?

Posted by: owenz on April 24, 2007 at 11:00 AM | PERMALINK

Touts - Sorta like, "I got a horse right here" Dial 1-800-SUCKERS.

How is this any different than the old days of horse racing? Sharpies would make a very large wager very early, on Horse A - Lemmings would follow and lower the odds - At the last minute, the sharpies would cancel their bet on A and switch to Horse B, whose odds had increased due to the lemmings. Sort of a pump and dump.

Most tracks disallow this procedure today.

Posted by: thethirdPaul on April 24, 2007 at 11:05 AM | PERMALINK

So why are people willing to pay fees of 20% or more to hedge fund managers? What am I missing?

20% is the percentage of the profits only. Most hedge funds operate on a rule of 2 and 20 -- that is, investors pay 2% of the amount held under management and 20% of the profits.

And that's about all I can contribute to this discussion, since this is my field.

Posted by: Stefan on April 24, 2007 at 11:28 AM | PERMALINK

Hedge funds provide their investors with a lot of prestige.

Posted by: Brojo on April 24, 2007 at 11:47 AM | PERMALINK

.I really don't get hedge funds.

Anyone care to enlighten us?

a. it's not your money.

b. if the investors don't like the returns, they move their money somewhere else.

Posted by: mabel on April 24, 2007 at 12:42 PM | PERMALINK

So why are people willing to pay fees of 20% or more to hedge fund managers? What am I missing?

Simple. It's the Cocktail Party Theory of Investing, to wit, securing one's place with alpha-male tales of financial derring-do trumps value-maximizing rationality any day of the week, especially those with happy hours. That's the only reason why in this profession so many can make so much doing so little.

Posted by: Katie on April 24, 2007 at 12:53 PM | PERMALINK

I think part of it has to do with human pyschology....everyone who got killed when the tech bubble burst in 2000-2002 is desperately trying to get back to where they were.

Therefore they are grasping at straws and being fleeced like cattle by inexperienced hedgies who have never managed a down market (remember the market has been up five years in a row since the crash ended).

The downside of hedge funds in not only that most of them are promising more than they can deliver, but also that they lack transperancy and are extremely illiquid. Most of them refuse to tell their customers how their money is being invested and only allow you to withdraw money once or twice a year.

Posted by: mfw13 on April 24, 2007 at 12:53 PM | PERMALINK

Many of the comments here suggest that you have to be crazy to invest in a hedge fund. But hedge fund investors include some of the most conservative institutions, like Swiss banks. The truth is that the best hedge funds do very well, and the averages do not tell the whole story. George Soros made quite a bit of money via his hedge fund. The Renaissance Technologies fund has averaged 37% annual return for almost twenty years. And D. E. Shaw & Co. has also been minting money for a long time. (These last two were founded by former academics who used considerable analytical skills in developing winning strategies).

And MsNThrope, you seem to be associating the whole idea of credit with fiscal irresponsibility and evil hedge funds. Yet the whole economy revolves on credit -- and credit derivatives are used by most mainstream institutions as conservative insurance policies. As for "9 times GDP" -- many people carry mortgages that are several times their take-home annual pay.

Posted by: JS on April 24, 2007 at 1:49 PM | PERMALINK

So what taxes did the $350 million dollar man pay? Or is that a stupid question?

Posted by: Fred on April 24, 2007 at 3:03 PM | PERMALINK

Hedge funds are used by the people who worship market efficiency to exploit what they claim doesn't exist - market inefficiencies. In other words, it is a rigged game. Small investors cannot participate, due to the high initial investment requirements. They also are unregulated, and can therefore invest in anything (e.g. pools of bankrupt airline fleets), which constrains small investors, but not large ones.

In short, hedge funds are a stellar example of the unevenness of the financial playing field and the inherent bias toward wealth and privilege in the American legal and financial systems.

Posted by: The Conservative Deflator on April 24, 2007 at 3:15 PM | PERMALINK

Dollar nears historic lows
The Gilded Age Top Hedge Fund Managers Earn Over $240 Million
Is it April, 2007 or April 1927?

Posted by: Mike on April 24, 2007 at 4:23 PM | PERMALINK

Brad DeLong is now quotable? Considered a non-fringe authority?

About time.

Although to be honest I have no idea how often he gets consulted about economics.

Posted by: MNPundit on April 24, 2007 at 4:58 PM | PERMALINK

1 A Hedge Fund’s fees and expenses-which may be substantial regardless of any positive return- will offset the Hedge Fund’s trading profits. In a fund of funds or similar structure, fees are generally charged at the fund as well as the sub-fund levels; therefore fees charged investors will be higher that those charged if the investor invested directly in the sub-fund(s).
2 Hedge Funds are not required to provide periodic pricing or valuation information to investors.
3 Hedge Funds and their managers/advisors may be subject to various conflicts of interest.

1.) Very true, but many of the top hedge funds are closed to new investors. So the only way you could gain exposure is through a fund of funds.

2.) Not true, hedge funds are audited by 3rd parties like PwC, Deloitte, etc. And if you're stupid enough to invest in a HF that's not audited, then don't complain. Also, nearly every major HF provides at least quarterly valuations (and most provide monthly).

3.) This statement could apply to everyone in business, politics, etc. In the HF world, reputation is everything. (and yes I know that Enron guys are working at HFs, but remember that while Enron was a crooked company, not everyone who worked there was a crook).


Lastly, everyone here seems focused on return, but don't forget about risk. Many of the top funds churn out 1 to 3% a month, regardless of market conditions.

That low standard deviation is very valuable to institutional investors (DB pension plans, endowments, etc) who have to make regular payments. The University can't stop construction on a new building because the S&P took a dip.

Posted by: naturallight on April 24, 2007 at 7:06 PM | PERMALINK

naturallight, auditing standards in the US preclude using mark to market accounting unless the asset is held for sale. The audit is of cost basis, that is not a valuation, it's an audit.
There is no requirement for periodic valuations, it doesn't mean there aren't funds which do supply financials. Those financials are likely cost based or priced as of a date some 45 days before issue. That's pretty much what you get in public companies.
As to the 3rd point see this article:
...as well as enforcing rules regarding personal trading by fund employees. They also wonder whether the independent-minded partners will even pay attention to what a chief compliance officer has to say, the article says.
http://www.itbusinessedge.com/item/?ci=12088
The 3 items I listed came from here:
http://www.hedgefund-index.com/

Posted by: TJM on April 24, 2007 at 9:19 PM | PERMALINK

The answer would be this:

http://www.pbs.org/wgbh/nova/transcripts/2704stockmarket.html

Posted by: pjcamp on April 25, 2007 at 12:26 AM | PERMALINK




 

 

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