A More Reasonable Hedge Fund Fee Structure

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.

Bounties Spur Innovation

Interesting column by David Wessel today discusses prizes offering a unique incentive for innovation.

The U.S. and other modern capitalist economies rely on a handful of approaches to stimulate innovation.

Big corporate research-and-development shops invest shareholders’ money in the search for future profit. Small entrepreneurial start-ups do the same with venture capital.

Academics toil in big universities, sometimes for profit, sometimes for glory. Open-source software wizards mend and tend shared software that no one owns, the high-tech equivalent of a barn-raising. Government steps in where private money fears to tread.

Now, a proliferation of prizes is attracting bright minds to stubborn problems.

U.S. Regulation Destroying Market Efficiency

Market efficiency depends on the ability to freely trade secure interest in Assets (i.e., goods, services, and the corporations that produce them).  Indeed, markets are enabled by two characteristics: Security and Liquidity.  Security is the ability to register and retain ownership of an Asset; an asset is Secure if it is resistant to theft or destruction by others.  Liquidity is the ability to exchange an asset for another of equal value: The owner of a Liquid Asset does not have to pay a significant fee to sell an Asset for its full value.

Without Security and Liquidity the gears of capitalism wear down and can grind to a halt.  Conversely, enhancing Security and Liquidity can result in as much economic production and progress as the development of Assets themselves, since without the ability to Secure and Liquidate Assets there is little incentive to produce them in the first place.

Capital market regulation in recent years has begun to cannibalize Liquidity in an attempt to enhance Security.  Michael Malone explains today in the WSJ:

In the zeal to punish the excesses of the dot.com boom, the federal government, with the tacit approval of the electorate, sought to not only punish the small number of real evildoers but also build the perfect universal plugs for all of the perceived holes in existing business practices.

The result was Sarbanes-Oxley, Regulation FD and stock option valuation — three great lessons in the law of unintended consequences. Let’s do our own accounting: Thanks to this troika, fewer new companies are going public; economic power is being concentrated in the hands of fewer companies; competition is reduced; new wealth is less widely distributed; the rich are getting richer; fewer talented people want to join entrepreneurial ventures; and corporate boards are getting stupider and more paranoid. And, please note, one of the crucial triggers for economic booms — a burst of young tech company IPOs — has now largely evaporated.

Just curious, but is this really what federal regulators, Congress and shareholder rights activists had in mind?

The Committee on Capital Markets Regulation offers a good set of analyses and recommendations for enhancing our capital markets.  They suggest that we can measure the competitiveness of a capital market with figures like the “listing premium,” which is the increase in stock price created by listing a stock in one market versus another, and which would be based on the enhanced regulatory assurances to investors minus the increased costs of regulatory compliance.  Indeed, the listing premium of U.S. stock markets has collapsed recently, and there is evidence that it’s not just because foreign markets are getting more competitive.

Defer Your Social Security Benefits

Assuming you enjoy at least average health and life expectancy, the best way to decide when to take social security benefits is to price them in terms of annuities.  Scott Burns walks us through an example that shows it’s generally worth deferring benefits if you can afford to.

Making Real Estate More Liquid

Real estate typically combines two distinct and risky financial assets.  One is the underlying property, whose value can fluctuate widely in response to interest rates and localized demand.  The other is the cashflow of the property, which consists of income from rents and costs from taxes, insurance, maintenance, etc.

Compounding the risks of these real estate components is that fact that neither is very liquid: Securing rental income for a property requires finding and maintaining renters.  Properties themselves can typically only be liquidated in “units” that start in 6 figures, and the transaction costs associated with buying or selling property can run upwards of 10%.  (Dot-com entrepreneurs take note: We’re still waiting for the internet to work its magic on this market!)

Finally, there is no way to buy insurance against property or rental declines.  In contrast to equity and fixed income, you can’t really sell short, buy puts, or otherwise hedge a long exposure to a particular real estate investment.  (You can, however, hedge the risks of appreciation using long-term leases.)

Granted, it is possible to buy diversified real estate exposure in a liquid fashion, through REITs (Real Estate Investment Trusts) and other real-estate-intensive companies.  But most people will still end up locked into a single, often highly-leveraged piece of real estate: their home.

If you are a property owner and you want to hedge against a decline in your property value, your options are neither extensive nor palatable:

1. Sell, and become a renter instead.
2. Sell, and move to a different region where you believe there is less risk of a decline in values.

Individual real estate is clearly a market ripe for innovations in liquidity.  Due to the size of the market, any entrepreneur who introduces practical liquidity mechanisms stands to make an enormous fortune.

Likely innovations would:

• Separate the cashflow component of real estate from the underlying property component.
• Subdivide the property component into more tradable parcels.
• Allow owners to hedge against declines in both cashflow and property value.

Today a venture called Rexx Index was announced that’s making steps in this last area, albeit only for commercial real estate.

Personal-Finance Salesmen Pedal the Retirement Myth

I suppose we can’t blame Robert Pozen for trying to drum up more business for his MFS Investment Management company, but his proposal for government-mandated retirement accounts is over the top. Rather than reforming our current social security programs, which require contributions by both employers and employees, he actually advocates creating a second more-complicated requirement for employers and employees to sock away even more money, this time in personal “retirement” accounts hamstrung by numerous government rules and regulations.

“Retirement,” as peddled by both entitlement politicians and personal-finance salesmen like Mr. Pozen, is a completely obsolete concept. It is based on the premise that an average American will reach a point in life at which he is unable to work for income. This may have been true generations ago, but today we enjoy a service economy in which even the severely disabled can find productive employment.

Furthermore, individual income requirements should actually decline over a lifetime. Even the most unskilled blue-collar worker in America has the opportunity and capacity over a 40-year career to own a home and send his children through college. With no debts and no future obligations, any unskilled senior who is willing to work can certainly support and insure himself without a “retirement” fund. Granted, there is always an individual risk of severe or long-term disability along the way, but we have both government social security and private insurance programs that address those risks and casualties.

As Americans live longer and healthier lives, they will continue to be capable of productive activity well into their old age. 21^st-century retirement should not be thought of as the time when a citizen is no longer capable of working. Rather, it should be the milestone at which an individual is free from major future obligations, and therefore free to pursue interesting employment with minimal concern for income.

Ongoing Moral Hazards in Money Management

There is a moral hazard for investment managers to take big unjustified risks:  They are gambling with other people’s money.  In general, managers share proportionally in the rewards when they succeed, but do not share proportionally in the losses when they fail.

For example, mutual fund managers are generally benchmarked to an index and they “succeed” to the degree that they outperform their index.  Success brings in more investors, which brings in more fees that the manager takes home.  Failure to beat the index may result in attrition of assets.  But in the worst case the manager doesn’t lose money they way his investors lose theirs.  He just has to start a new fund without the bad track record, or take another job.  Thus, the incentives for a new manager who wants to make a fortune, but who doesn’t have any special ability to beat the market, is to take a gamble with a portfolio that is riskier (higher beta) than his index.  Any such portfolio could outperform or underperform the index.

Suppose the manager has “won” his gamble and as a result has captured more investments.  Eventually, he may become content with his elevated position, at which point he will stop gambling, which means the investors who bought in expecting him to beat the index will now just be owning the index — but will still be paying extra management fees to their exceptional manager, who in fact is just a lucky gambler.

Hedge funds exacerbate this hazard, because the risks can be essentially unlimited, and the payoffs to managers from big wins are nearly immediate.  One would hope that after a hedge fund manager blows up with an unjustified gamble that would be the end of his career in the industry.  Today’s WSJ reveals that such a hope may be in vain:

Brian Hunter, the natural-gas trader behind last month’s massive losses at hedge fund Amaranth Advisors, is exploring whether to get back in the game, people familiar with his plans say.

He approached Wall Street contacts to gauge investor interest in backing him, these people say, and may decide whether to resume energy trading in a few months. …

Amaranth, based in Greenwich, Conn., is liquidating, after Mr. Hunter’s bad bets triggered roughly $6.4 billion in losses, or 70% of its assets.

An executive recruiter in contact with Mr. Hunter says he has offered to help introduce the once-highflying trader to investors. The recruiter sees opportunities for Mr. Hunter to make a fresh start with high-net-worth investors, possibly in Russia and the Middle East.

Mr. Hunter was estimated to have made at least $75 million in 2005.

So here’s a manager who took home something like $75MM in incentive fees for making enormous gambles with other people’s money.  He banked his fees, and the next year not only lost more than half his investors’ money but also destroyed his employer.  Not only does he not lose any of his own money, but apparently there are still people out there who want him to gamble their money.

Betting on fallen hedge-fund stars isn’t all that uncommon. John Meriwether, who led Long-Term Capital Management until its 1998 implosion, now runs another hedge fund.

Account for Global Public Goods

This is a problem worth drawing attention to: Old Europe’s bloviations are writing checks their defense budgets can’t cash.

In fact a majority of the world’s countries are not paying their fair share for the security they enjoy.  It seems easy to argue that, at least in a free country, GDP is a fair measure for assessing security taxes.  After all the more production the more a country depends on the world markets and the more utility it enjoys from increased world security.

According to the World Factbook we can see that most free countries are not spending as much as the United States on defense, as a fraction of GDP.  Americans are devoting 4% of our production to defense.  And as we have seen time and time again, our peerless military is the only force capable of successfully overthrowing genocidal and terrorist regimes, securing world commerce, and acting as a first-responder to both global catastrophes like the 2004 tsunami and regional conflagrations like the invasion of Kuwait.

When an American pays $4 in taxes to secure Middle-Eastern oil, stop genocide in Serbia, and hem in that North Korean maniac menacing the Pacific Rim, a German pays just $1.50, and our self-righteous neighbors to the North are spending just $1.10.  But everyone benefits from the global peace and security we are providing.

It’s time for the United States to start billing for its services.  Granted, we have no authority to tax other countries.  But we could start accounting for the defense debts of other nations.  For example, Spain spending just 1.2% of GDP on defense is short its fair share by $27BB for last year alone.  For 2005 Italy owes $32BB and Japan is down over $110BB.

The next time these countries start whining about the U.S. not paying its dues to the United Nations or not donating enough cash to earthquake victims let’s just add up their security debts to the United States — already trillions of dollars, and growing!

And if for some reason the United States agreed to an economically burdensome treaty like, for example, the Kyoto Protocol, we should first deduct our defense credits from our share.  It would be a long time before we had to cut any of our carbon emissions.

The Overdue Death of Pensions

The Wall Street Journal expounds on the latest legislation to overhaul private pensions, noting, “the idea of a single company guaranteeing retirement payments for decades is no longer practical, if it ever was.”  Frankly, that is an understatement.

Defined-benefit pensions are annuities.  Annuities are an insurance product.  Unless you happen to work for an insurer, your employer has never been regulated as an insurer or rated for the health of its reserves.  What business does an airline or car manufacturer have writing insurance for its employees?  Yet that is what all these private companies were doing with their defined-benefit pensions.

It would have been fine if they had literally been funding a deferred annuity written by a proper insurer.  But as we know they neither fully funded their pensions nor did they offer the sort of portability that would come with a true annuity contract.

Fortunately, that scam seems to be coming to an end.  But there is still the matter of government defined-benefit pensions: Many federal, state, and local government agencies offer these to their employees.  I suppose that since they are being backed by governments they do not suffer the same credit risks associated with private companies.  Many agencies also collude to provide some degree of pension portability, so an employee can switch jobs without losing his benefits.

But government pensions still suffer from the underfunding hazard — with the cost and risk being dumped on taxpayers.  I suspect pensions will persist in government if for no other reason than that they are a convenient way to hide the cost to taxpayers of benefits provided to one of the classically strong special interests: government employees.  For this reason, taxpayers should demand that governments fully price and fund their pensions.  Or better yet: abolish them and let people buy their own annuities if they want.

After American Capital Market Hegemony?

I never thought I’d see the day that the United States would lose its hegemony in the world capital markets.  Alan Murray, in his essay yesterday, “Fees May Be Costing Wall Street Its Edge In Global IPO Market,” notes that Wall Street investment banks are roughly twice as expensive as their foreign competitors.  “Does anyone really believe they deserve 7% of the capital raised by a newly listed company?”  Of course, it may not be long before America produces a crop of discount IBanks.

But later Murray points to more systemic faults in our capital markets, and these realy could cost us our capital superiority:

New Treasury Secretary Henry “Hank” Paulson Jr. — former chief executive of Goldman Sachs — … said there’s no simple answer to America’s IPO problem. “Markets overseas are much stronger, more competitive than they were a few years ago,” he said, “so that’s one of the reasons.”

He also cited the U.S. “legal environment” (read: trial lawyers), the “enforcement environment” (read: New York Attorney General Eliot Spitzer) and the “regulatory environment” (read: Sarbanes-Oxley) as contributing to a reluctance to raise new capital in the U.S.

The Inefficient Market for Corporate Leadership

I rarely disagree with the Wall Street Journal’s editorial board, but today’s essay on CEO compensation is incongruous.

There’s been a lot of griping about executive pay recently, and Hank McKinnell’s severance package, estimated to be worth $83 million, will do little to damp the indignation.

But Mr. McKinnell’s surprise ouster as CEO by Pfizer’s board last week illustrates the flip side of the executive-pay coin: Top executives in the U.S. are paid for performance, and today’s corporate directors are not shy about pushing out those whose performance doesn’t measure up for shareholders.

It’s great to see that boards are firing underperformers, but the thing that really shocks the conscience is the compensation levels.  And the fact that even when they fail these CEOs win.  Walking away with an $83MM severance is not what anyone would consider punishment or failure.

Currency Arbitrage

Ending penny production has been a topic of debate since as early as 1990.  Now that it costs more than face value to mint pennies and nickels there has been enough written on the subject that I don’t need to revisit the arguments here.

I have kept a stash of pennies in my hardware organizer for years.  Metal washers cost at least a nickel, so it’s generally cheaper and easier to drill a hole in a penny and use that.

But this is just funny: Apparently pennies minted prior to 1960 are worth 3-6 cents to collectors, and any penny minted prior to 1982 contains 2.5 cents of copper at current rates.

Brings back a whole other meaning to “currency arbitrage.”

What is Parenting Worth?

We all had a good laugh when Salary.com suggested that the fair wage for a stay-at-home mother is $134,121, not least because while they suggested that every mother spends time as a CEO and a Psychologist, they neglected to mention her valuable work in the oldest profession.

There is, however, an interesting question along those lines: What is parenting worth?  We often forget that people are productive resources.  Therefore, producing people is itself a productive endeavor.  So what is the marginal value of producing a typical person?

Have you checked your money market accounts lately?

A Money Market is the most liquid and least risky investment you can buy.  If you have any significant amount of cash sitting around, it should be in a Money Market Account (MMA) or fund.  With the inflation rate also breaking the 2% level, a typical checking or savings account will not even preserve your money’s buying power.  But Money Markets roughly follow the Fed Funds rate, which is now 5.25%.  Or at least they’re supposed to.

I was recently reviewing MMAs at Citibank, Wachovia, and Commerce Bank, and I discovered that all three of those banks have MMAs with current rates as low as .25%!  I confronted all three and asked them how they could advertise a product as a money market and pay a rate completely divorced from the money markets, which have been climbing steadily since July 2004.  All three basically answered, “We can pay whatever rate we want.”

Looks like a class action waiting to happen, but in the meantime there’s no reason for anyone with more than a few thousand liquid dollars to be accepting rates below 1%.  Instead, open a brokerage account with a company like USAA, Vanguard, Fidelity, etc., and put the money in one of their money market funds currently yielding more than 4.7%.

For a premium there are also MMAs that are FDIC insured.  And if you’re in a very high tax bracket there is probably a tax-exempt money market fund for your state that would give you about the same after-tax yield.  In any case, just be aware that you can’t trust your bank to pay a fair rate on your money.

Gaming Financial Management

In the Wall Street Journal today Ron Lieber described Randy Kurtz’s RK Investment Advisors, a money manager with a novel product: He will invest client’s money in separately managed accounts. The core holding of every account is an S&P500 ETF. To quote from the article:

“Then, he plans to pick a couple of stocks each year and invest no more than 10% of his clients’ funds in each. … For his efforts, Mr. Kurtz keeps one-third of all returns above and beyond the return of that index. … If the portfolio doesn’t beat the benchmark, he earns nothing.”

Sounds great, right? You get your beta and, if he’s a great stock picker, you also get the alpha from that. And if his picks go south, presumably he’s in a lot more pain than you, because he gets nothing – not even a management fee! Could incentives be any better aligned?

The answer: Quite. In fact, Randy Kurtz’s money management plan is nothing but a legalized form of three-card monte. If I’m in his position, here’s how I play it: First of all, I spend $10 in commissions to get each client’s money into the ETF in a margin brokerage account. Then at random I pick a high-volatility stock or two, which I buy on margin. The trick is that I pick different stocks for each of my accounts. Then all I do is wait. Some stocks will outperform tremendously, and I will share 33% of their profit (above the relatively low cost of margin, trading, and the ETF management fee). Some stocks will tank, and I personally lose nothing. Essentially, I’m playing the lottery but somebody else is buying the tickets! Of course, my losing clients will probably leave. I may even encourage them to. After all, when I’m trolling for new money I would like to say that I have made outsized returns for the majority of my clients. I will sweep my losers under the rug and polish my winners to attract the next marks. [Update: Mr. Lieber clarifies that Mr. Kurtz claims to hold the same portfolio across all clients.  While odd, this does resolve the moral hazard I suggest here. Please see Comments for further clarification!]

The asset management industry hosts plenty of swindles. I’m not talking about full-fledged frauds here – fortunately both the industry and the government do a good job of controlling those. Rather I am thinking of fully-disclosed financial products that would never be purchased by people who really understand them.