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Wednesday, May 23, 2007

Are Hedge Funds Worth It?

Are hedge funds a good deal for investors?:

Worth a Lot, but Are Hedge Funds Worth It?, by David Leonhardt, NY Times: ...Institutional Investor’s Alpha magazine released its annual list of the highest paid hedge fund managers... James Simons, ... who was at the top of the list, earned $1.7 billion.... Down at No. 3 on the list, Edward S. Lampert of Greenwich, Conn., the investor who owns a large chunk of Sears, made $1.3 billion...

Today, Alpha magazine will release another big list, and this one offers a chance to answer another, arguably more important, question: Are these billionaire hedge fund managers really worth it?

The reason hedge funds are a license to print money is their fee structure. A typical fund charges a 2 percent management fee, which means that it keeps 2 cents of every dollar that it manages, regardless of performance. Mutual funds, on average, charge about 1 percent.

On top of the management fee, hedge funds also take a big cut — usually at least 20 percent — of any profits that exceed a predetermined benchmark. So in a good year, a fund’s managers bring in stunning amounts of money, and in a bad year, they still do very well. ...

Last year was actually a pretty tough year for the industry..., the Standard & Poor’s 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees...

But the men ... who appear on Alpha’s list of top earners don’t manage average hedge funds. They manage the biggest funds in the world, the ones that are winning the Darwinian competition for capital, and many of them aren’t having any trouble beating the market. One of the funds at Mr. Simons’s firm ... delivered a net return of 21 percent last year. The other returned 44 percent after fees. And Mr. Simons, who relies on a fantastically complex set of algorithms, doesn’t charge “2 and 20”... He charges “5 and 44” — a 5 percent management fee and 44 percent of profits — yet he has still been doing very well by his investors for almost two decades.

I realize that a lot of people find 9- and 10-figure incomes to be inherently excessive. Or even immoral. From a strictly economic point of view, however, they are also perfectly rational. You cannot find anyone else who is providing the same returns as the best hedge fund managers at a lower price. If you don’t like it, you don’t have to give them your money.

(Even if you do like it, they probably won’t take your money. In exchange for being lightly regulated, hedge funds are open only to wealthy investors and big institutions.) ...

“The best performance is coming from the largest funds,” said Christy Wood, who oversees equities investments for the California Public Employees’ Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.

But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years won’t be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments. The world is awash in capital. All that capital, of course, also translates into ever-greater management fees, regardless of a fund’s performance. ...

Outside of the highfliers on the Alpha list, ...[s]ince 2000, the average hedge fund hasn’t done any better, after fees, than the market as a whole, according to research by David A. Hsieh, a finance professor at Duke. Still, even mediocre managers, after a lucky year or two, are able to attract gobs of capital and charge “2 and 20.”

So are today’s hedge fund managers really worth it? Sure, but only if they deliver the sort of performance that Mr. Simons has, and very few will in the years ahead. More to the point, it’s extremely difficult to know who the stars will be.

In all sorts of walks of life, people tend to think that the past is a better predictor of the future than it really is. That’s why ... so many investors chase returns. The genius of the world’s hedge fund managers isn’t only in how they invest their money. It also lies in having set up an industry that takes advantage of a timeless human trait.

    Posted by on Wednesday, May 23, 2007 at 02:07 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (12)

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