The Best Way to Get Rich Quick – for the Hedge Fund Manager (an analysis of returns)

November 13, 2008 · Posted in Big Business Ripoffs, Financial Crisis, Thoughts on the economy 

The very best way to get rich quick has, for the last 15 years or so, been to start a hedge fund.  Now the case I am about to present is an odd topic for this blog because the money that hedge fund managers make is not taken out of the pocket of the average Joe / Jane.  In fact, for the most part, it is wealthy individuals and private endowments that have made a bunch of very young people (mostly white men) very rich.

So my beef is not with the hedge fund managers for taking advantage of this, it is with the wealthy individuals and endowments who liked the notion that they had a “better mousetrap” for making money.

Now, to the extent that some of the tactics employed in the attempt to make the better returns promised by hedge funds have hurt companies – and I think they have – then the average Joe / Jane and their congressional representative do have a serious beef.

But the subject of this blog is simply the value proposition to hedge fund investors.

I ran a simulation, and without getting too technical, I assumed an average annual return for the “market” (however you want to define it) of 10% with a standard deviation of 15% (for statisticians out there, I did assume a log normal distribution of returns).

Now, I hope (and expect) that a PhD in finance will run a more comprehensive test of the hypothesis I am about to posit.

My hypothesis is that if you make generous assumptions about the ability of hedge fund managers to out perform the market (create “alpha”) the fee structure of hedge funds combined WITH THE TENDANCY OF HEDGE FUNDS TO SHUT DOWN WHEN THEY DIP INTO NEGATIVE RETURNS GREATER THAN 10% (rather than earning back their investors money, they prefer to start a new fund and have a “fresh shot” at the performance fees with out having to get back to their high water mark – i.e. get their clients money back) creates a payoff pattern for hedge fund investors which over full market cycles yields a LOWER average return than a diversified portfolio.

I assumed that the universe of hedge funds could create an excess return of 2% over the “market” in any given environment.

I also assumed the standard hedge fund fee structure of 2% of assets and 20% of profits.

I assumed that a hedge fund would shut down for any return of negative 10% or more.

I ignored the impact of other transaction costs.

I ran 100 trials in a monte-carlo simulation and found that factoring in the reduction in returns associated with the performance fees in good times (which often more than offset the 2% “alpha” assumed in the simulation) and the fact that the investor was often left “holding the bag” in periods of significant negative returns the hypothetical hedge fund universe underperformed by 2.6%.

I think the assumptions used are reasonable, though I do not claim to have employed any “academic” rigor in coming up with them.  In fact, I think it is very likely that there is no net “alpha” created by hedge funds as an industry (there are just too many of them, and they are not all “that good”).

I am not arguing that certain managers and certain strategies may, for periods of time, be able to create excess returns, I think certain of them absolutely can do this.

I think the implications of my analysis are that, particularly for newer funds and managers, wise investors will insist on strong “claw back” provisions to re-capture past performance fees if future performance were to be sub par.  I think that hedge fund investors should require that hedge fund managers keep a significant portion of their performance fees set aside in treasury securities for some period and they should only be able to realize these fees over some period of time.

Now I do not really care, as I am just an average investor.  If people want to keep making these guys (they are mostly guys at this juncture) insanely rich with no real value added then that is their right to be stupid with their money.

I do hope someone with greater intellectual resources will tackle this issue – not just the fee structure and ability of funds to generate alpha, but the way the tendency to shut down after periods of negative performance skews the return distribution to hedge fund investors.

If you do, please inform me of your findings.

Tags: , , ,

Comments

2 Responses to “The Best Way to Get Rich Quick – for the Hedge Fund Manager (an analysis of returns)”

  1. Robber Baron on November 13th, 2008 3:51 pm

    It is the gift that keeps on givin the whole year round, Clark…. hehe

    A fool and his money are soon parted, and better me to receive then give that’s what I say.

  2. massiveproducers.info on April 2nd, 2009 4:53 am

    massiveproducers.info…

    The concept of talent swapping is borrowed from the professional sports industry. In sports, winning is everything, and it is a common practice for team management to externally seek out a“ superior” player in a key position to replace a struggling…

Leave a Reply

You must be logged in to post a comment.