Investors need to starve the hedge fund beast; The industry model mainly benefits intermediaries

November 11, 2013 7:38 pm

Investors need to starve the hedge fund beast

By Jonathan Ford

The industry model mainly benefits intermediaries, writes Jonathan Ford

Asked in the late 1970s how he saw the outlook for the specialist investment vehicles that he is credited with inventing, Alfred Winslow Jones was no optimist. “Thehedge fund doesn’t have a terrific future,” he said gloomily. Hedge funds’ investment styles were too easily copied, and the inefficiencies on which they thrived too swiftly eroded. They would never, Jones thought, become a big part of the investment scene.Were he alive today, Jones would be astonished at theresilience of his creation. No longer the preserve of wealthy private investors, hedge funds are part of the mainstream, managing a stunning $2.5tn, much of it from pension funds. This far exceeds their $1.9tn pre-crisis peak.

One thing, however, has not changed. That is the fee structure Jones devised to finance his original $100,000 fund in the late 1940s. True, there has been some erosion of the celebrated 20 per cent performance charge, which, together with a yearly management fee, accounts for a fund’s income. But this has been marginal. For all their supposed purchasing power, institutions have yet to pare prices.

Fees designed to sustain Jones’s small, research-heavy shop have thus been transposed on to giant funds, some worth double-digit billions. When added to the hefty trading expenses hedge fund investors willingly bear, the resulting cash flows are truly prodigious.

These do more than fund the enviable lifestyles enjoyed by those who run these firms. They bankroll a broader informational arms race that many funds and their proprietors appear to deem necessary to secure their prosperity.

Hedge funds are extraordinarily expensive to run. Huge sums are needed to hire the skilled traders and analysts upon whose judgment their fortunes depend. And that is before the IT and other information costs a hedge fund incurs, let alone the fees it pays to intermediaries, especially investment banks.

Unsurprisingly, these costs bear heavily on the returns received by investors. In a book published last year, Simon Lack, an investor, estimated that since the 1990s, the fees charged by hedge funds and funds of funds had eaten roughly 98 per cent of the returns they made.

A recent insider trading case against SAC Capital, the hedge fund founded by Steve Cohen, underlines the model’s lavishness. SAC’s very high fees – Mr Cohen had thechutzpah to charge not the customary 2 and 20 but 3 and 50 – allowed it not only to hire the most highly regarded traders but to do so in such profusion that each was responsible for only a handful of stocks.

Portfolio managers were paid not on the basis of the whole fund but just on the performance of those few companies for which they were responsible. As SAC was a so-called event-driven fund, managers had to scour every scrap of information they could glean that might move the prices of these shares.

SAC’s labour-intensive approach certainly delivered superior returns. In five of the six years between 2006 and 2011 it outperformed the average hedge fund, often by a wide margin. The snag was that much of the information that some at the firm were trading on was improperly obtained.

SAC may have broken the rules, but in many ways the staff who transgressed were just doing what all hedge funds do – seeking an “edge”. Other companies have different ways of achieving the same end, whether flinging money at prizewinning mathematicians to devise algorithms that can sniff out market inefficiencies, or paying hefty fees to stock exchanges to place computers on their premises – which gives a timing advantage measured in fractions of seconds.

Investors have been tolerant of these tactics, even though the returns from them appear to have dwindled in recent years. But it is questionable how much this edge really benefits the institutions whose cash now makes up the majority of hedge fund money.

Pension funds are exposed to the whole market, not just to hedge funds. So to the extent that hedge funds deliver gains at the expense of conventional investors (or each other), pension funds risk being unwitting participants in a zero-sum game, in which the gains in one fund are offset by losses elsewhere, minus the costs of the transaction. This is a model that, ultimately, benefits the intermediaries, not the end investors.

Some years ago, the all-in costs of hedge fund investing, including fees to investment banks, were estimated at more than 7 per cent of funds invested. That exceeds the long-run returns from the stock market. As such it is unsustainable. AW Jones’s prediction were a touch premature. But on the substance, he may yet be proved right.