The world is finally beginning to wake up to the truth about hedge funds:Hedge funds are, generally speaking, AMAZING wealth generators for the smart people who run them–and a complete rip-off for their clients.
Yes, there are a handful of hedge funds that have done spectacularly well for their clients. Whether these funds will continue to do spectacularly well for their clients is an open question–and it’s the clients who are bearing all the risk that they won’t–but it’s true that a handful have done well.
The vast majority of hedge-funds, however, just charge above-average fees for below-average performance (or worse).
But the good news for the world’s investors is that that word is finally beginning to get out.
The first chart shows the distribution of the “profits” that hedge funds generated in the 12 years through 2010. (You can quibble with Lack’s methodology and precise conclusions, but the overall picture is probably close to the truth.)
The red is the portion of those profits that were retained by the hedge funds in the form of management fees and performance fees.
The yellow is the portion of the profits that went to “fund-of-funds” that helped investors invest in the hedge funds (for additional management and performance fees).
And the green is the portion that went to the actual investors.
Photo: Simon Lack, Eric Falkenstein
A second chart shows how this appalling result was achieved.
For the first 10 years of the period, the hedge funds generated modest performance each year, and the clients received a healthy chunk of that performance.
But then came 2008.
In 2008, the hedge funds lost more than they had made in the entire decade before that. And 100% of those losses were covered by the clients. (The hedge funds, meanwhile, still collected their management fees.)
Photo: Simon Lack, Eric Falkenstein
In case this doesn’t make it clear enough why hedge funds are a “heads we win, tails you lose” value proposition for investors, let’s go through the numbers year by year.
For example, let’s consider a hypothetical hedge fund called Capital Compensation Partners, LLC.
Let’s assume the firm raised a $1 billion fund at the end of 2002 with a typical 2/20 fee structure: 2% annual “management” fee and 20% of any “performance.” Let’s say the fund manager invested the entire fund in an S&P 500 index fund on Jan 1, 2003.
Here’s how the hedge fund would have done over the next six years:
2003 Performance: +25%
Client Assets At Year End (less fees): $1,185,000 (+$185 million)
Total Fees: $65 million
2004 Performance: +10%
Client Assets At Year End (less fees): $1,257,000 (+$72 million)
Total Fees: $46 million
2005 Performance: +2%
Client Assets At Year End (less fees): $1,253,000 (-$4 million)
Total Fees: $30 million
2006 Performance: +14%
Client Assets At Year End (less fees): $1,370,000 (+$117 million)
Total Fees: $58 million
2007 Performance: +4%
Client Assets At Year End (less fees): $1,389,000 (+$19 million)
Total Fees: $36 million
2008* Performance: -39%
Client Assets At Year End (less fees): $820,000 (-$569 million)
Total Fees: $27 million
Total Hedge Fund Fees Over 6 Years: $261 million
Total Client Performance Over 6 Years: -$180 million
To summarize: Over the six years Capital Compensation Partners was in business, the firm made about $250 million, and the firm’s clients lost about $200 million. All the risk, meanwhile, was borne by the clients, who got obliterated in the end.
It’s no secret that hedge fund managers are a super-smart lot.
How do we know that?
Because they went into the hedge fund business!
After all, what’s the worst thing that can happen to a hedge fund manager? He can lose so much of his investors’ money that they yell at him and take the rest back.
Nothing ventured, nothing gained.
And what’s the best thing that happen? Well, John Paulson’s $3.7 billion compensation in 2007 is a reasonable benchmark for hedge-fund managers to shoot at.
Wait, John Paulson? Isn’t he the guy who incinerated about half of his clients’ money last year?
Why yes he is!
Because past performance is no guarantee of future results. Except with respect to fees.
(And, no, John Paulson didn’t give back half of the $3.7 billion he made in 2007. That’s his to keep.)
Of course, most hedge fund managers are neither failures nor John Paulsons–they’re just somewhere in the middle. They do pretty well in years in which the markets are going up, and they get clobbered when they’re going down.
How well do these hedge-fund managers do?
Because the hedge-fund business is the best business in the world. Unless you’re a client.