Doing the Hedge Fund Hustle
The lure of this weird, murky business persists. And so do the big payoffs--sometimes.
FORTUNE
Monday, March 17, 2003
By Carol J. Loomis
The word out of Cambridge, Mass., is that this year's graduating students at Harvard Business School have a yen above all to work in the hedge fund industry--and to some people already knee-deep in this business, that's about the scariest proposition around. Said one successful hedge fund manager recently: "Business school grads are often a leading indicator of trouble. Think about their mad rush into investment banking, management consulting, and tech. If they now want hedge funds, are we the next to go?"
Now, there's a good question--if not exactly an answerable one. There's another puzzler that goes with it: Just why should Harvard's newly minted MBAs, whom you'd normally expect to be chasing prosperity, have a rage for this business right now anyway? The fact is that hedge funds (of all kinds, including equity, fixed-income, commodities, and currencies) have just come through a year in which the average fund appears to have made virtually no money. We resort to "appears" because hedge funds do not have to publicly report their performance, and therefore all the data that exist about the overall results of the industry are both incomplete and squishy. Nevertheless, the many compilers of hedge fund statistics seem to agree that 2002 was at best a "blah" year, which is the adjective used by Robert Jaeger, chief investment officer of Evaluation Associates Capital Markets, one of the compilers. His index, based on 100 funds following several diverse strategies, shows that the average hedge fund made 2.2% last year (after all fees) for its investors. Morgan Stanley's MSCI, with an index including about 640 funds, has a higher figure, 5.4%. But the Hennessee Group, whose index takes in 680 funds, shows a loss of 3.4%.
This is a world that HBS students are thirsting to enter? Well, yes, because what the recent record obscures is the seemingly limitless potential that hedge funds have for minting money--for their managers, at any rate. These funds earn incentive fees--possibly rich and remarkable fees--based on how well they perform. The usual deal is that the manager takes 20% of annual profits. That's on top of an annual management fee that investors pay, which has generally been 1% of assets. But at some funds with muscle the rate has been rising, to 1.5% or even 2%. (The story goes that one marvelling Wall Streeter asked his hedge fund friend how in the world he made a deal at 2%. "Well," said the manager, "it's only because I couldn't get 3%.") Out of the profit cut and the once-standard 1% management fee comes the "one and 20" description that is often applied to the compensation structure for hedge funds. Compare that take with the 1.7% or so expense ratio (which includes staff compensation) of a really good mutual fund--Bill Miller's, for example. HBS students, it seems, can do math.
Another part of this industry's appeal right now is that the stock market's terrible results in 2002 make the hedge fund universe look as if it's bursting with stars. The total return for the S&P 500 was -22%, and the total return of the average mutual fund, according to Morningstar, was -19%. Over the past five years as well, hedge funds appear--there's that word again--to have outdone the major market benchmarks. So what's bad about "blah" for the hedge funds?
The recent edge they've had naturally arises from that word "hedge," which means that most funds work at protecting themselves from a down market by engaging in short-selling. Some funds specialize in shorts, and they certainly had a banner year in 2002 (when 364 stocks out of the S&P 500 index fell), posting returns in the 15% to 30% range. Depressing the overall hedge fund average, though, were equity funds that operate with what's called a "bias" for long positions and therefore use shorts sparingly. These funds were in the 15% to 30% camp on the down side.
But back to our puzzle from up top: No matter how you cut the cake, it's tough to argue that 2002 was a good year on average for the people who run hedge funds. For them to get rich by raking in their 20%--for them to prosper as those HBS wannabes are imagining is possible--they need to make what the industry calls "absolute returns." These are positive returns, as distinguished from the "relative returns" that much of the money-management industry talks about. If a mutual fund manager--take Bill Miller again--loses only 19% while the S&P 500 is losing 22%, he congratulates himself on good relative returns.
If a hedge fund manager is down 19% for the year, he's had a train wreck. He's earned no incentive pay and, besides that, has lost 19% on any money he himself has in the fund. In addition, his partnership agreement with his investors may incorporate what's called a "high-water mark." This means that if $1 invested has fallen in year one by that 19%, to 81 cents, the manager must in year two or thereafter get his investors back up to $1 before he begins again to earn his 20% take of the profits.
Trapped in that kind of situation, a hedge fund will often be tempted to pile on risk, trying to make up ground fast. Evaluation Associates' Jaeger, author of a 2002 book, All About Hedge Funds, calls that "going for home runs" rather than the "singles and doubles" that would probably be best for the investor. Some funds that have lost a big chunk of their capital deal with adversity still another way--choosing simply to fold and return their investors' money. Since chutzpah is definitely not lacking in this industry, a fund of this type may promptly reorganize, once again seeking investors' cash--but with the slate conveniently wiped clean.
As the very notion of a losing, folding fund suggests, hedge fund indexes are subject to some unknowable degree of what's called "survivorship bias." That is, they are pushed up by the fact that the total hedge fund universe at any given moment doesn't include poorly performing funds that have recently been driven from the business. That adds, of course, to the squishiness of the data.
Even so, no amount of mystery in this business has kept it from expanding: Hennessee Group estimates that in the past ten years the number of hedge funds has grown from 1,100 to 5,700. Against that, there are only about 4,750 mutual funds. But the average mutual fund has about $550 million in assets against a much lower $120 million for the average hedge fund. That's before leverage, of course, which many hedge funds use to the hilt, sometimes destructively--as Long-Term Capital did before it failed, in 1998. "Liquor and leverage," the saying goes. "One or the other accounts for most of the world's ills."
The biggest hedge funds run to a good many billions of dollars in asset size--and that, for sure, is a mixed blessing. If a fund does well, size presents its managers with prodigious wealth. But size is also the enemy of performance, because it gets in the way of nimbleness when funds are acquiring and unloading positions. Moreover, many hedge fund managers regard the business today as unhappily crowded and competitive, particularly where short sales are concerned (see Where the Money's Really Made).
All of the above should prompt yet another question: If it's hard for hedge fund managers to make a consistent killing, what are the chances for investors? With the one-and-20 formula, after all, investors are buying into just about the most expensive form of money management there is. Simplistically, here's how it plays out. Say Fund A had a percentage gain for the year of a quite respectable 16%. From that, the typical fund would first subtract its 1% take of assets, leaving the gain at 15%. Next, the fund would capture its 20% of the gain--that is, three percentage points. The investor would be left with a 12% gain to take home or, alternatively, to reinvest in the fund. In either case, he'd be liable for taxes on the gain (which are apt to be mainly short term).
And wait--there might be an additional fee before he realizes any gain. In recent years there's been a boom in intermediaries called "funds of funds." These parties, typically sponsored by brokerages, banks, and independent consultants, bundle and then parcel out the money of wary investors hoping to spread their hedge fund dollars around intelligently. The compensation arrangements for funds of funds range all over the lot, but could well lift another two percentage points from the investor.
Thinking about this plunder, William J. Crerend, author of a 1998 book called Fundamentals of Hedge Fund Investing, concluded that he knew the hedge funds' lineage: "To take a little poetic license, pirate ships of old were a bit like today's hedge funds, if you can imagine a bunch of wealthy investors outfitting a ship and sharing the spoils with the crew."
We can carry that analogy a touch further: If an investor is set on boarding a hedge fund ship, he'd better be good at picking a skilled captain. In this game, as in all forms of money management, it comes down to who's steering. A hedge fund investor isn't going to earn the industry's average. He's going to earn--or lose--in line with his talent for choosing managers. |
