Tuesday, January 8, 2013

On Hedge Funds

From this The Economist article:

WHEN it comes to brainboxes, the name "Nobel" has a certain ring. But news that the Nobel Foundation plans to increase its investment in hedge funds, because years of low returns forced it to cut cash prizes in 2012, is one to leave laureates scratching their eggheads. The past year has been another mediocre one for hedge funds. The HFRX, a widely used measure of industry returns, is up by just 3%, compared with an 18% rise in the S&P 500 share index. Although it might be possible to shrug off one year's underperformance, the hedgies' problems run much deeper.

The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply.

The article points out a simple portfolio of 60% stocks, 40% bonds would have returned 90% this past decade. Hedge funds produced more like 17% over the same time frame.
(See chart in the article.)

The article also points out there are star performers every year but, sometimes, whoever it happens to be in any particular year doesn't necessarily repeat the performance.

...a third have lost money, including some of the stars of yesteryear: John Paulson, celebrated as an investment wizard in 2007 for having foreseen America's housing bubble, reportedly saw his flagship fund lose 17% in the first ten months of 2012, after a 51% fall in 2011.

Interestingly, John Paulson topped the list of best paid hedge fund managers in 2010 with $ 4.9 billion in pay, after being 4th on the list of highest paid managers in 2009 with $ 2.3 billion, and 2nd on the list in 2008 with $ 2.0 billion.

Not surprisingly, Paulson wasn't on the list in 2011 considering what happened to fund performance that year.
(The 2012 list will probably be out within a few months.)

Here's who was on the 2011 list.

The Rich List

Top 5 of 2011
1 Raymond Dalio (Bridgewater Associates): $ 3.9 billion
2 Carl Icahn (Icahn Capital Management): $ 2.5 billion
3 James Simons (Renaissance Technologies Corp.): $ 2.1 billion
4 Kenneth Griffin (Citadel): $ 700 million
5 Steven Cohen (SAC Capital advisors): $ 585 million

Highest Paid of 2011
Highest Paid of 2010
Highest Paid of 2009

Typically, hedge fund compensation comes from the 2 and 20 fees (2% of assets and 20% of profits above a certain level or some variation of that arrangement), but also comes from increases to the value of whatever stake a manager might have in their fund(s).

What I'd like to focus on here is not the gains that come from the money these managers have invested in their funds (especially if those invested funds DID NOT come from accumulated fees charges in prior years) but, instead, on the money made from the hedge fund industry standard "2 and 20" compensation structure.
(This type of compensation structure includes a management fee that's 2% of assets under management. It also includes, when applicable, a performance fee for 20% of the profits -- sometimes above a certain threshold -- or some similar variation.)

A good chunk of the above earnings comes from fees though, of course, this varies greatly by fund.

To keep this simple but meaningful, let's consider a hedge fund with $ 20 billion in assets under management (excluding what the fund manager has kept invested in the fund). Many of the larger hedge funds have more than that much under management -- some much more -- so it's a reasonable scenario.

Now, in a year where a hedge fund generates, let's say, a 10% return -- what is, of course, a $ 2 billion increase -- that means the frictional costs for investors in would roughly be:

2% of $ 21 billion plus = $ 420 million
(The fund would have increased from $ 20 to $ 22 billion so I've used the midpoint.)


20% of the $ 2 billion profit = $ 400 million

= $ 820 million

These rather huge frictional costs couldn't contrast more greatly with the model that exists within the Berkshire.

The above fund managers may all be excellent at what they do, but these rather huge frictional costs are quite a contrast to the $ 100,000 per year that Warren Buffett is paid (plus/minus whatever change to the substantial amount of stock he owns) and has been paid for decades. Some, at the very least, of the prevailing compensation systems in the industry seem, by comparison, more than just a bit heads I win, tails I win even more.

It's not difficult to see -- looking at the assets under management multiplied by a typical hedge fund fee arrangement -- that a large proportion of the earnings by many hedge fund managers comes from the fees themselves.

Of course, Buffett has done just fine, but his wealth has come primarily from the increase in value to the shares of Berkshire Hathaway's (BRKa) stock.

That is stock he bought decades ago with his own money. So it is Buffett's own investment in Berkshire's stock long ago that, for the most part, made him wealthy. The wealth did not come from his Berkshire compensation package.*

As a result, the frictional costs to shareholders of Berkshire has, in fact, been minimal.

If Buffett hadn't been allocating capital well all those years, he couldn't have become rich. He also couldn't have done well without other Berkshire shareholders also being rewarded.

The capital he put at risk inside Berkshire long ago is the primary basis of his substantial wealth. Crucially, his wealth is not from compensation that could have subtracted meaningfully from Berkshire's intrinsic value over time. If it had been in the form of substantial, the reduction in returns for continuing long-term Berkshire shareholders would have been substantial.

Buffett's compensation has remained modest by just about any standard over these past decades. Naturally, I think it's fair to say that expecting others to take that kind of pay cut is, other than in exceptional cases, just not very realistic. I also realize Berkshire is not a hedge fund. Still, those that are very good at capital allocation -- even if not willing to accept a paycheck reduced to the size of Buffett's -- shouldn't really mind if the prevailing compensation systems moved at least directionally toward the Berkshire model. In other words, more wealth from appreciation of their own capital (and there are certainly managers with a bunch of capital in their funds) side by side w/investors, less from fees/other forms of compensation that subtract from total return (and the capital base). Those who are very capable investors would, in the long run, still be able to do very well for themselves indeed.

Of course, the less able capital allocators might not like it a whole lot.

So Berkshire may not be a hedge fund, but the company has been built around the effective allocation of capital. Their approach has worked well over time, has proved to be adaptable, and continued working well once it had some scale (though there are certain things it cannot do due to sheer size). While the company's unique strengths can't easily be replicated by others, it's tough to see why the world wouldn't be better off if the best qualities of Berkshire (including the extremely low frictional costs) wasn't the prevailing model used by others in the business of capital allocation. Berkshire would now be a shadow of itself if Buffett had been compensated like a hedge fund manager all these years.

The Economist article points out the industry can rightly claim that certain hedge funds have performed extraordinarily well longer term. The problem for an investor is figuring out who that's going to be in the future among the 8,000 or so hedge funds that exist. Also, for even those that do well, the frictional costs are plainly still very much there.

No matter what, the Berkshire way seems by far closer to the model we'd want most allocators of capital to be emulating. Very low frictional costs combined with a greater focus on long-term effects. Above average results with less risk (that's risk of permanent capital loss...not beta).

Now this obviously isn't about to happen anytime soon. The current accepted norms and ways of doing business are far too lucrative for that to happen.

Still, some wise changes along these lines wouldn't seem to be a bad thing at all.

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

Well, many hedge funds are charging a whole lot more than .5 or 1 percent.

It's worth considering the compounded effect of these frictional costs on overall long run wealth creation (even if individual fund performance is exceptional) for investors as a whole. The world's not better for it. Nor is it better off with so much talent being absorbed into various aspects of money management. Talent that could potentially be rather useful elsewhere. Yet, with it being so lucrative, it's not really hard to understand why someone would make such a career move. It's the system that exists. Tough to blame the participants. They're just going where the money is.

So I doubt it changes anytime soon. That doesn't mean there aren't real long-term consequences.

"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." - John Maynard Keynes

Keynes The Money Manager

We're capable of creating a system of capital formation and development that better serves investors and society as a whole.


Related posts:
Highest Paid Hedge Fund Managers
Bogle: "Tyranny of Compounding Costs" - Part II
Bogle: "Tyranny of Compounding Costs"
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Munger, and the 90% Tax
Heads I Win, Tails I Win...

* In other words, compensation that would reduce Berkshire's per share intrinsic value. Beyond the salary, Buffett does have personal and home security paid for by Berkshire. Otherwise, no bonus, stock options, stock grants, and certainly not the kind of management fees charged by hedge funds. (The portfolio he manages -- not to mention the operating company -- is substantial in size compared to almost any fund.) An apples-to-apples comparison to hedge fund frictional costs would also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (including the costs associated with the two investment managers). Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Now, during Buffett's partnership era, he was paid fees that compensated him well on the upside though also gave him exposure to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering a quarter of all losses from his partners. From Alice Schroeder's book, The Snowball"I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
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