Heads I Win, Tails I Win...

...even more.

2009 Compensation for Top 5 Hedge Fund Managers:

1. David Tepper: $ 4.0 billion
2. George Soros: $ 3.3 billion
3. James Simons: $ 2.5 billion
4. John Paulson: $ 2.3 billion
5. Steve Cohen: $ 1.4 billion

Some managers are no doubt very good. When you look over multiple years, investors in many hedge funds (not necessarily those run by the above five) end up with modest returns after subtracting the fees (often 2% of assets, 20% of profits) that are paid to hedge fund managers. The reason? Hedge fund managers get paid well in years when the returns are high yet still can get paid (merely a lot) when the returns are not.

To make the point clearer, here's a simplified example (using the 2% and 20% fee structure):

In year 1, if a hedge fund with $ 10 billion in assets delivers a 50% return. The hedge fund makes $ 1.2 billion and investors make $ 3.8 billion.

Ok, that may or may not seem fair but...

In year 2, the same fund drops 33%. The hedge fund makes over $ 200 million (the 2% fee on the average amount of assets as they decline during the year...~$ 11.5 billion for the year) and the investors have $ -4.8 billion ($ -4.6 billion from the decline in assets and $ -200 million in fees) of losses.

Summary of the 2-Year Returns

• Investors: A -10% return and $ -1.0 billion loss. The $ 10 billion of assets at the beginning of year 1 are now worth ~$ 9.0 billion ($ +3.8 billion year 1 and $ -4.8 billion year 2).

• Hedge Fund Manager: $ 1.4 billion in compensation. This comes straight from the $ 1.2 billion in first year plus the $ 200 million in the 2nd year (an infinite return since no capital of their own is required...though, to be fair, some certainly have plenty of their own money invested).

The incentives provided by the prevailing method of compensation in the industry seem designed to not serve investors. I would like to think that there are examples of better incentive pay structures out there, it's just that the 2% of assets, 20% of profits is the norm.

Adam

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