While most of the public’s attention has been directed towards the earnings of CEOs and private equity managers, the real money is being earned behind closed doors in those mysterious places known as hedge funds.
After stuttering following the collapse of Long Term Capital Management in 1998, hedge funds have exploded. It is estimated that the 100 largest US hedge funds control more than $1.1 trillion in assets. These funds charge investors on a similar basis to private equity, with clients paying around a 2% management fee plus 20% of profits above the benchmark (known as alpha).
This remuneration method allows hedge-fund managers to earn obscene amounts of money. Institutional Investor’s Alpha magazine compiles a list of the top 100 hedge-fund managers’ earnings. As noted in the New York Times, James Simons, founder of Renaissance Technologies, earned US$1.7 billion last year. Simons’s fund returned a very impressive 84% last year. In return for this performance, Simons (who uses mathematical algorithms to determine investments) charges investors a very hefty 5% base fee and a 44% performance fee.
While his pay was astronomical, at least Simons provided a return for investors. The same can’t be said for Raymond T. Dalio, head of Bridgewater Associates. Dalio, who manages US$30 billion in assets earned US$350 million last year, despite returning only 3.4% — far worse than the S&P. Dalio received his massive payday purely due to management fees.
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Investors in hedge funds eloquently prove that saying about fools and their money. When the market is booming, any buffoon with a margin loan or CFD account can out-perform the market. For example, between 1 January 2006 and 31 December 2006, the Dow Jones went from 10718 to 12463 — and increase of 16.3%. Using an extreme example, had a hedge-fund manager (or a trader with a CFD account) used 10% capital and borrowed 90%, they would have returned almost 100% after interest by simply investing in the index.
Let’s say a hedge-fund manager has $1 billion under management; if he used the strategy mentioned, he would earn a management fee of $20 million and a “performance” fee of $200 million. Less expenses, a hedge fund controlling $1 billion of equity could earn well over $200 million for doing nothing more than borrowing money and following the index. (No hedge fund would just invest in the index though, they usually take futures positions or basic takeover arbitrage to vindicate their fees).
The use of debt to magnify returns is an effective strategy during a boom, but when the inevitable correction occurs, hedge-fund investors will suddenly realise that they have been paying far too much for far too little. Of course, if a hedge fund makes a large loss or even goes under (such as LCTM or Amaranth), the ‘star’ hedge-fund manager will certainly not be returning all those management fees or refunding the investors the capital lost due to their incorrect ‘bets’.
Warren Buffett put it best in a recent interview where he noted that “on Wall Street, there are innovators, imitators, and total incompetents. I’m afraid that the majority of hedge funds around the globe now are run by the latter two categories of people”.