The Hedge Fund Disconnect

As I watch and read about the Hedge Fund testimony currently going on, its obvious that the right question has not been asked.

1. Those who give money to hedge funds rarely if ever have a 1 year investment term. In fact, the contracts for investment do everything possible to lock up your money for as long as possible.

vs

Hedge Fund Managers pay themselves on an annual basis.

That is a huge disconnect and there in lies the rub. While it is true that the managers are paid on a performance basis (plus their 2pct of assets) and some even have clawback provisions, that is not enough. If a fund can get big enough, all they have to do is max out in a single year and the managers are set for life. They put hundreds of millions of dollars EACH in their pocket.

The investors on the other hand, can not max out returns in a single year. They are locked in. So there is a huge disconnect. Managers think short term, investors long term.  Managers should be paid on their performance over a much longer period.

If you made the minimum period for managers 36 months, you would see wholesale changes in how investments are made by Hedge Funds.

So, back to the Testimony today. The questions I would ask ?

How long does the average investor stay in your funds ? Why arent you paid based on the same term rather than annually ?

35 thoughts on “The Hedge Fund Disconnect

  1. I am surprised to see such a generalized viewpoint given such validity.
    by you Mark. Most Hedge funds have lock up periods shorter than 1 year. Those
    managers with proven long term track records can convince investors to lock
    up their investment, because their track records suggests they wont swing
    for the fences 1 time to make a killing.

    Comment by Barret -

  2. Congress and the S.E.C. should dig deeper since most hedge funds are bought with the “help” of some advisor. On the institutional side, a lot of wining and dining of pension fund committees has led to hedge fund managers putting the retirements of employees and university endowments at risk. For individuals, a lot of brokers and other financial salesmen should be held accountable for putting clients into investment funds with one-sided fee arrangements and mis-matched time horizons. I agree that full disclosure in and transparent exposure solves a lot of problems, so why doesn’t the hedge fund inquisition delve more deeply into the good ‘ol boy distribution network? Or would that take the inquiry too close to Goldman Sachs, Morgan Stanley, and a large number of union-associated fund consultants who also happen to be large donors to Congressional candidates? Individuals need to be held accountable – but so, too, do their advisors.

    Comment by Doug M -

  3. The last two commenters — Nick, and Da’vid A — hit several nails on the head.

    I want to make several points: the main one being that the ideal fund investment these men discuss does exist. There are certainly others, but my firm is one of them.

    We manage separate client accounts, but all get the same investments pro-rata. I invest capital as if we were a fund. But clients have full access to see both the value of their account and the investments held. It’s 100% transparent. My firm also does not have any “lockup” provision — clients have the right to walk away anytime.

    We settle up every quarter, and of course use a high water mark as any respectable manager would. This means that the timeframe mismatch Nick mentioned truly does not apply to firms like mine. If we were to lose a lot of client money — they’d leave, no strings attached. . The risks are rewards are very appropriately aligned.

    That said, performance-based fees are in my opinion by far the best way to compensate your investment managers. The rationale is obvious and needs no further explanation. .

    It’s a mistake to group all hedge funds or all peformance-fee-based managers into this negatively-viewed camp. My firm is one of several that offers clients full transparency and an alignment of interests not found at most mutual fund shops. I’m motivated to kick ass for clients, and am proud of our official 2 1/2 year record of nearly 10% IRR.

    Our firm’s summary can be found at http://www.teewinot.us/FactSheet.pdf .. in case you’re interested.

    Comment by Buck Woodford -

  4. Not all hedge funds have lock in periods. I know of new funds that
    liquidate every 3 months. and don’t forget high water marks.
    In these times, an investor needs to not only looked for a fund that
    is performing(there are some that are with no down months in 2008)
    but one that has no lock in periods and full transparency.
    That is the only way to be attractive right now because these
    are changing times. That will be the norm eventually.
    In regards to the credit companies, no they do not hold a gun to the
    persons head but they do spend a lot of money on marketing
    that will influence people who are not discipline to handle credit
    cards. It’s similar to writing those sub prime loans. The credit card
    companies have their hand in the congress’ pockets and get them to
    pass favorable laws that go against the consumer. There should be
    be more oversight on the credit card industry.

    Comment by DA'VID A -

  5. I am a financial advisor here in town and have been pounding my fist on the table for years arguing this point. Good questions Mark. Check out the compensation structure for the Mutual Fund managers at American Funds http://www.americanfunds.com. They are paid on rolling 4 year averages were most managers at both the hedge fund and mutual fund level are paid on their past 1/4 of performance. American Funds managers do not have the luxury of making this years shitty return magically disappear when the calendar rolls from 2008 to 2009. They must live with their performance for the next 4 years so they are forced to act like LONG TERM investors and not “in it for my self and myself only” traders.

    I hope that this helps guide people to the right place and away from hedge funds in general.

    Comment by Nick Thomas -

  6. I have to disagree with your statements. This is still the United States and (for now) people can still make a living. If investors think that 2/20 or hell, even 3/30 is reasonable, then so be it.

    I would never pay those fees, but obviously a lot of wealthy people do.

    Comment by dave -

  7. More than likely anyone reading this blog is aware how dilutive PIPE deals can be. If I just invested a large sum of money in a company and they immediately went out and, essentially behind my back, diluted the heck out of me, I’d feel betrayed and want to dump all my stock and wash my hands of the entire company as well. However, I’m not qualified to offer any opinion on the “right” way to dispose of such shares. Perhaps others here are.

    Comment by Jeff Mitchell -

  8. Nice discussion. I also don’t think government regulation of the merits of a particular HF compensation structure is the way to go; however, disclosure requirements may not be a bad idea. On the other hand, if disclosure requirements are mandated as with mutual funds and securities generally, the HF as an investment strategy may lose one of it key strategic advantages – stealth. What begins as a mere requirement that HFs disclose their management compensation structures may turn gradually morph to include myriad other disclosure requirements. Generally, the wealth and sophistication of the investors in HFs is thought sufficient to protect their own interests. Be careful about inviting the government into the process because, once in, beuraucrats (eager to advance their carreers and grow their own names and power) will find new way to “help” the HF market operate more “efficiently” or with “a more level playing field.” Give an inch, they may take a mile.

    Comment by joseph -

  9. SEC Files Insider Trading Charges Against Mark Cuban
    http://www.sec.gov/news/press/2008/2008-273.htm

    The usual caveats apply: innocent until proven guilty, there are two sides to every story, always keep an open mind, etc.

    Comment by Jeff Mitchell -

  10. Cuban – Not sure why you have a problem with Hedge Funds, unless you happened to have picked the wrong one, or maybe you are jealous that these smart managers actually make more money than you. The risk adjusted returns for many of these investment limited partnerships significantly outperform any other investment alternative. Just like anything else, there are some good product/managers and there are some bad products/managers. Every investor in these partnerships is required to sign the partnership agreement that identifies every risk under the sun in addition to the suitability questionnaire. Why don’t you stop bashing a great industry that has made billions for investors, the entrepreneurs and employees that manage the funds, the government that reaps the benefits thru taxes. What happened to capitalism?

    Comment by R Dean -

  11. Mark –

    I think that you are out on the ledge… everyday; it is the life of the risk-averse, the true enterpreneurs.

    However, contrary to first blush impressions, I feel hedge fund managers are perhaps more like leeches, and are not the entrepreneurial wealth creators people believe – sucking the life out of every ego that feeds them… seeking short term gains in lieu of creating long term wealth for families believing in the American dream. Now seeking short term gains is gambling, so let’s call it a game and perhaps stop calling it investing.

    the issue here I believe is that many may not see them as the socialists they in fact are: moving wealth from the small investor to the wealthy – for that too is a form of socialism since it is made permissable by political structure; if done by pure free will, well perhaps that would be a different matter entirely.

    so, as admirable as it might sound, I believe you remain a true entrepreneur – as a former one, I applaud your efforts to remain honest in spite of your great wealth. Fortunately, at least some of the policies of this country have permitted you the freedom to do just this: provide a breath of fresh air for everyone seeking some simple truths. You in fact do not have to do this – you could smugly resort to remaining counseled to say nothing, embraced by walls. It is patriotic I think to speak up and push the boundaries of discourse.

    I look forward to reading more.

    B

    Comment by B R -

  12. I don’t understand how some of you think it’s reasonable for ANYBODY to put restrictions OF ANY KIND on the amount of money a hedge fund manager makes???

    Again, if you read the terms & conditions and decide the manager makes too much money, DON’T INVEST!!!! PUT YOUR MONEY SOMEWHERE ELSE!!! YOU ARE FREE TO DO THAT!!! Welcome to America!

    WOW THAT’S EASY!!!! JUST DON’T GIVE THEM YOUR MONEY!!! Their salaries will come down after enough people do that … supply and demand again.

    If a guy is SO DARN GOOD that he makes $150M/ year as a fund manager, FINE! If he’s BAD, don’t invest with him!

    Very similarly, if you determine a mutual fund’s expense ratio is too high, DON’T INVEST IN IT!!

    If the price is too high … Don’t buy.

    “.. hedge fund owners are the only ones making money … these funds need to be regulated” RIDICULOUS!! TAKE YOUR MONEY OUT THEN!!! They do not need to be regulated by ANYBODY other than the investors who can simply take their money out if they don’t like the fact that the manager is bad at trying to increase your money. If all investors take their money out of Hedge Fund A, its manager will HAVE TO FIND ANOTHER JOB. So simple. When you suck at your job, you get fired. Investors, fire the guy if you’re unhappy with him, or if he makes too much money … or both.

    I’d argue that everybody who thinks hedge fund manager pay needs to be regulated is far off enough on that thinking that they will be too dumb to take their money out when they don’t like how it’s going … Thus, the bad HF manager who “makes too much money” gets to continue doing so.

    Comment by Jeff -

  13. Mark,

    I disagree with your assessment and have posted my reply to your
    thoughts here on my site:

    http://richard-wilson.blogspot.com/2008/11/hedge-fund-connection-mark-cuban.html

    – Richard
    Hedge Fund Blogger.com

    Comment by Richard Wilson -

  14. Excellent post…….the hedge fund owners are the only ones making money…….. these funds need to be regulated

    Comment by SEO Links -

  15. Pingback: theceodaily.com» Morning Update » November 14, 2008

  16. Wall Street works off of the same principle, a bad quarter can set a company back even if they have excellent long term prospects.
    Check out http://www.Credit-card-cap.com I put this website up well over a year ago and slowly but surely it is all coming together the way I suggested back then. Rather than credit-card debt “forgiveness”, which has already been rejected as a proposal, just allow people to pay off their debts interest free.

    http://www.DailyPUMA.com

    Comment by Alessandro Machi -

  17. we do 1 year terms with a renewal option at month 9.
    we offer a hurdle rate of 6% before we trigger our management fees.
    we started with 2MM and 2 people.
    we are now doing much more than that and our private investors are happy.

    Comment by dave -

  18. Mark,

    Thanks so much for your blog, your insight is valuable.

    Keep it up!

    Go Mavs.

    -Jo

    Comment by Jo -

  19. Good point about when they get paid, but the only regulation I see
    necessary in that is full disclosure to the investor. So many “advisors”
    conveniently leave out the information about their own interest in
    your actions and decisions. The disclosure needs to be in plain English,
    in writing, and featured in a prominent place so the average person
    will read it and understand it.

    Thanks for the post, Mark.

    Comment by Jillian -

  20. Mark,

    Excellent point. But HF’s are sold as super-sexy vehicles and hence all the money piled in without regard to the terms and conditions. As someone else commented, performance should be paid on out performing some benchmark not some low hurdle rate. If the fund outperforms then benchmark then the manager gets 50% of everything after that, however need to have a long term provision in there.

    mrj

    Comment by Manish Jain -

  21. “We need to regulate the amount of money invested in an individual fund.”

    Vanguard might not like that idea.

    Comment by Mario -

  22. Mark,

    Thank you for great postings and discussions.

    Why set any minimum for the fund managers? Your last sentence is just perfect, why not match the bonus period with lock up period. In this case, managers will most likely want to reduce the lock up period, while investors would want to extend it. Then it’s up to both parties to find mutually acceptable ground.

    See you tonight at the game in Chicago?

    Best,
    GS

    Comment by Well Informed Optimist -

  23. Another thing. If the regulators crack down too much, these guys will move offshore. The treasury can say good bye to the money that they pay in taxes.

    Comment by Jason -

  24. Why do you care Mark? No one is forcing people to invest in hedge funds. If you don’t like the terms, don’t invest.

    Comment by Jason -

  25. Investors in hedge funds are some of the most sophisticated investors in the marketplace. They chose to enter into a contract with these hedge funds at arms length, if the pay provisions were short sighted and promoted improper incentives, then it is the investor’s fault. If you want to propose regulation for pension funds or government investors on what kind of fees they can agree to pay, that is a different matter.

    The answer to your last question is obvious by the way, they were paid yearly because they could be. The hedge fund managers were in it for themselves, and they got the best deal they could.

    I am not even sure Congress can directly regulate hedge funds, at least not alone. It is too easy to base a fund out of the Caymans, Dubai, etc. and securities markets are now pretty global. If Congress tries to turn hedge funds into broker-dealers or mutual funds, expect them to move overseas. Nassau is much nicer than Manhattan or Greenwich anyway.

    Comment by jkoerner -

  26. Mark,

    When you compare hedge fund management fees with mutual fund expenses, they are roughly the same. This base management fee covers technology, trading, salary, administrative, and auditing expenses. Now, when hedge fund managers are taking 20 percent of the fund’s overall performance, I think this is where we need to question the structure. You should be paid on the outperformance compared to an index such as the S&P 500 or Russel 3000.

    We need to regulate the amount of money invested in an individual fund. As your assets grow the fund becomes immobile. There is too much money chasing too few opportunities.

    I could talk about hedge funds and investments for days! But I won’t; back to work!

    Best,
    Michael

    Comment by Michael -

  27. Mark,

    Excellent point. A similar disconnect exists in the securitization business with underwriters, legal, ratings agencies, etc… Payments are loaded on the front end which makes volume, rather than quality the number one priority. I discussed it a little here.

    Comment by WindyInc -

  28. Just proving the point… that those who really know how to make money investing keep it to themselves, and those who are paid to do it do it just well enough to not get fired (most of the time).

    Comment by Richard -

  29. This is an interesting idea of ALWAYS tying performance and production to pay. It seems as though if all compensation was tied to output it would be a much more market approach and efficiencies would improve. I don’t know that an hourly pay system is the answer because I can do nothing in an hour but I could also product 4 hours of output in one hour if I’m kicking ass. It basically comes down to business owners doing a better job of defining what they will pay for and how they will measure that performance. I learned in my very first job as a strategy consultant that if you tie rewards to goals you WILL reach those goals…if they are not aligned you are screwed! Great post Mark.

    Comment by Ryan Graves -

  30. The hedge funds “do” start with large assets. Most funds start from someone leaving a large investment
    bank and bringing some huge clients with them. Not unusual to start with over $500 Million in
    last 10 years. Even if you started with $100 Million and managed to do 15% just for one year =
    2% Fee, 20% incentive = $5 Million. Manage $1 Billion, and you can do the math.

    Also funds should have “high water” mark in order to get paid. If you started at $100mm, goes to
    $150mm, then back down to $90mm, most funds will reset incentive at $90. They can make money
    when client is in negative return (and have paid taxes on previous gains).

    Any funds created in last 2 years will definitely close because will be so far away from any incentive.
    Funds that have “high water” mark will also close, and just start a new fund, with a different name
    so they can have new start point for incentive.

    Also, regular “retail brokers” should be paid based on performance (total return for investors.)
    Worked at Merrill for 10 years, and drove me crazy that not once was I ever asked by any management
    “HOW MUCH DID YOU MAKE FOR YOUR CLIENTS THIS YEAR?” Will have to say at least the Hedge
    Funds are in the business to make their clients money. Even though a lot easier to make “lots” of
    money if you make ASSET Gathering the most important part of business…

    Comment by Will Appleton -

  31. Something I haven’t spent much time considering.
    I enjoy the blog, always something in here that makes me think.

    Comment by DallasKink -

  32. The reason they got away with it for so long is: (a) Until 2007, HFs did pretty well on returns for investors, so no one cared how much money they made (b) HNW individuals and institutional investors had a long investment timeline so they didn’t need to pull their money every year, (c) this was a way for HFs to maintain their “exclusive” status (d) HFs were relatively unknown to a large amount of “Main Street” investors so what they did and the money they made was not publicized like it is now.

    I don’t expect the 2/20 comp scheme to change for all the HFs that survive this financial crisis. They would have proven that they have a strategy that withstood the worst investing climate since the great depression and will be turning away billions by 2010. There might even be a proliferation of 3/30 funds. In any case the number of HFs (8,000+) will drop dramatically and the industry will return to its secretive ways. Remember when SAC Capital Chief Stevie Cohen avoided photographs and was considered a recluse? Damn that Trader Monthly!

    Comment by econ365 -

  33. I think if funds could “just decide” to have a massive gain one year at the expense of other years, they’d probably be able to have pretty good gains year after year.

    Futhermore, they have to start small, in order to attract investors.

    Nobody is making hundreds of millions of dollars in their first couple years.
    Then they are only going to get the investment capital if they perform well – not if they are somehow “saving themselves” for big single-year payday.

    I do see how this can occur on a (much) smaller scale – if I want to raise my year-end numbers I can sell some winners that I normally would have held on to if it was any other time – but I think you’re greatly exaggerating the abilities of fund managers to “time” their gains/losses.

    Can you give some examples as to how I would max out a single year at the expense of the future?

    Respectfully, Jon

    Comment by Jon -

  34. Noone is forced to invest in hedge funds or accept bad terms.

    Regulation should cover disclosure of terms in a plain and clear manner.

    Comment by Roger -

  35. You seem to want to blame and slam hedge funds; If they’ve done something illegal, then I agree with that, in fact jail time should ensue. But, what about the responsibility of every investor to educate themselves about the investment BEFORE handing over your money?

    You also seem to want to blame and slam credit card companies. Credit card companies may not be saints, but they didn’t FORCE people to buy crap they can’t actually afford. They also didn’t FORCE anyone to get a credit card. They merely offered, and people with debt accepted. Kinda like french fries … Micky D’s OFFERS them, but you do still have to ACCEPT and EAT them. Who in the world in this day and age doesn’t know french fries make you fat, and will probably eventually kill you if you eat too many??

    Some of this sounds like people trying to blame others for their own dumb mistakes.

    Comment by Jeff -

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