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A More Reasonable Hedge Fund Fee Structure March 21, 2007

Posted by federalist in Finance.
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Hedge funds are a legitimate financial industry, distinct from the retail industry of tax-efficient diversified mutual funds geared towards small investors and individual savers. However, the hedge fund industry maintains a fee structure that embeds an unusual moral hazard. The industry is ripe for an evolution in fee structure, but it may take a major and somewhat altruistic player to effect that evolution.

The Status Quo

Typically a hedge fund manager will collect a 2% management fee and on top of that will take 20% of any profits generated. This emphasis on performance incentives is a hallmark of the industry. But the incentive is almost always implemented with a peculiar feature: The fund manager gets to lock in performance fees at the end of each calendar year. He will keep this money even if he subsequently loses investor capital.
 
This fee structure creates perverse incentives. Because the manager shares directly in the upside, but risks nothing material on the downside, he has every reason to take excessive risks. In effect he is gambling with other people’s money. The annual lock-in produces a behavior known as the Wealth Effect: Managers who have accumulated large profits tend to reduce the risk they take towards the end of a calendar year in order to protect their impending payout. In contrast, managers who have lost tend to “double-down” and take excessive risks, in hopes of recovering and turning a profit they can harvest at year end. In each case the manager’s incentives are not aligned with those of the investors, who want to take exactly the appropriate level of risk regardless of how much has been made or where they are in the calendar.
 
A common fix to this problem is to establish a “high water mark” so that managers do not earn any incentives until they have entirely recouped losses.  The perverse result of this is that as soon as their performance draws down too much they tend to close up shop rather than stay in the game to recoup their investor’s losses.  After all, they do not earn anything extra by making money back.  The problem again is that they have still locked in past performance fees.  Often it is easier to take their past winnings and start from scratch somewhere else, where once again they are “above water” and immediately share in profits.  (This tendency for losers to quit has resulted in a notoriously large “performance selection bias” in the hedge fund industry.)
 
These hazards were on spectacular display at Amaranth Advisors where Brian Hunter, an energy fund manager, accumulated enormous paper profits in 2005.  He personally took home an estimated $75 million at the end of the year based on that performance.  However, he earned that money by taking huge risks, and just a few months into 2006 his positions collapsed.  Investors lost more than half of their money, and the firm promptly closed, but Brian Hunter kept his millions.
 
The Fix 

The industry is ripe for an evolution in incentive structures:  It is obvious that this needs to involve delayed vesting of performance fees.  Performance fees should be kept in escrow with a vesting period much longer than one calendar year.  Just as the exact performance share varies from fund to fund, the vesting period could vary; a reasonable period might be at least five years.
 
So long as investor money is at risk, performance fees should be at risk.  Granted, fund managers have to feed their families, so they would lock in their fees gradually over the vesting period.  But delayed vesting will keep their skin in the game even if they have a big drawdown.
 
To see how this would ameliorate all of the moral hazard inherent in the current incentive standard, imagine a hedge fund named Zamaranth funded by two equal investors, A and B.  During 2005 Zamaranth doubles its investors’ money, and the manager gets $100 million in incentive fees escrowed, vesting over five years.  Beginning 2006 the manager is earning $1.67 million each month from escrow – an ample payout from his stellar performance.  Soon investor A cashes out, and since that investor’s money is no longer at risk, the manager immediately banks $50 million from escrow.  A few months later, Zamaranth’s remaining positions collapse, losing all of the value they accumulated during 2005.  Investor B, having lost all his gains, recoups all of the performance money remaining in escrow.  The Zamaranth manager took a big risk, and he shared in the consequences.  But he is still incentivized to work for his investor, because he is not “below water,” so any profits he earns will immediately accumulate in his escrow account.

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1. federalist - March 24, 2007

Amusing news yesterday in the WSJ: Brian Hunter is launching a fund called Solengo Capital, which proposes to charge investors the standard 2%-and-20% fees.

Mr. Hunter is seeking hundreds of millions of dollars from overseas investors, potentially in Europe and the Mideast, people familiar with the matter say.

Although Amaranth’s recent loss of more than $6 billion makes it unlikely that he can raise capital from U.S. institutions such as pension funds, he could benefit from the willingness of cash-flush investors elsewhere to take risks in the commodities markets. Investors also can invest in Solengo funds that are separate from the portfolio that the 32-year-old Mr. Hunter will manage.

I guess old world investors aren’t familiar with the saying, “Fool you once, shame on me; fool you twice, shame on you….”

2. federalist - May 9, 2007

DeLong marvels at hedge fund fees. One Don Majors in the comments notes:

Most hedge funds are supposed to be low-beta. To the extent that their risk is truly idiosyncratic, it’s worth paying 2-and-20 even for lackluster returns, because they don’t add any risk to a portfolio. The ideal hedge fund, with a positive (but not necessarily large) expected return that is uncorrelated with any asset class (including other hedge funds) is theoretically worth paying a lot more for. The difficulty is in determining whether the true correlations are really so low.

3. federalist - June 7, 2007

BreakingViews.com today offers another illustration of the hazards of the conventional fee structure:

Want to invest in an undisclosed company, in an unidentified industry that needs a shake-up?

If this sounds like a dubious investment scheme, it might surprise you to know one hedge-fund manager, Pershing Square’s Bill Ackman, raised $2 billion with just such a pitch. Given his record, this may be sound. In theory, however, such single-stock funds take the “hedge” out of hedge-fund investing.

The original idea of a hedge fund was to make money regardless of the market’s direction. While there’s no reason that betting on one stock can’t accomplish that, it defies modern portfolio theory, which suggests diversification optimizes returns. However, from the fund manager’s perspective, betting on just one stock can optimize the fees they earn. Here’s how it works:

Take two fund managers, each with $1 billion that both take 20% of the profits as their fee. One puts the entire $1 billion into a single fund and invests in 10 stocks equally. The other invests in the same 10 stocks but sets up each investment as a separate fund of $100 million each. At the end of the year, five stocks gain 50%, two are unchanged and the remaining three fall by half. For the first fund — the one that hedged its bets by pooling winners and losers together — that brings a return of $100 million, and a $20 million fee for its manager. That’s not bad.

But consider the manager who segregated the investments into 10 separate funds. He gets no fee on his five flat or money-losing funds. But the big gains in his five winners aren’t offset by losses in the other funds, so he walks away with much fatter fees — it works out to a total of $50 million. This is essentially what Mr. Ackman does when creating funds targeting a single company.

So, are investors daft to back him? In his pitch to investors, while Mr. Ackman didn’t specify the target of his next campaign, he could point to similar funds he launched that went after underperforming companies — including McDonald’s and Wendy’s — and made investors a fortune. Given this track record, it’s easy to see why they’re backing him. But investors should be wary of untested copycats spinning similarly opaque promises.

4. federalist - July 31, 2007

Dennis Berman highlights the more general hazards of short-term unrecoverable incentive fees for long-term risks in the finance industry:

Despite the fallout, both bank and hedge-fund investors are willing to pay upfront money without seeing back-end results. The consequence is a free-rider’s paradise, where individuals can stack up the short-term benefits for themselves, while letting the institution bear the brunt of their actions.

The result is a banker getting handsomely rewarded in January for making a loan that blows up in August. The hedge-fund manager, meanwhile, is able to buy up billions in suspect subprime real-estate loans and derivatives, clipping a 2% management fee along the way.

5. federalist - November 9, 2007

This problem is reviewed at The New Yorker, and corollaries are identified in stock-option compensation of chief executives.

6. Hedge Fund Managers - March 2, 2008

I think hedge funds should charge 0 and 20%. If you are not making your investors money then why run a hedge fund? There are 10,000 hedge fund managers out there trying to make a living, so there is no need for new hedge fund managers unless you are certain you can do it.

– Richard
Hedge Fund Managers Blog
http://richard-wilson.blogspot.com/2007/10/hedge-fund-managers-pedigree.html

7. federalist - March 8, 2009

Pension funds are finally exercising their market clout to get better terms on hedge fund investments.

Performance fees should be spread over two or three years. Management and performance fees should come down as investors increase their allocation to the fund. Hedge-fund firms should disclose more about individual fund positions and the firms’ operations.

Institutional investors have clout in numbers. They account for the majority of the money invested in hedge funds, surpassing high-net-worth individuals….


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