Money managers keep most of the profits for themselves only leave crumbs to investors
Hedge funds represent a fascinating field of interest for two reasons. First, they involve the most sophisticated strategies and instruments, such as short selling, derivative products and leverage. Hedge fund managers have unequalled freedom of action, with a goal of maximizing profits. They represent active management in its most extreme form. Second, hedge funds attract the best and the brightest. As proof, the media regularly reports that some of the most talented traders leave their jobs at banks, investment advisory firms and endowment funds to launch a hedge fund firm of their own. It is well known that these traders — who are already very well paid by their employers — are generally motivated by one thing when they decide to go it alone: they want to make a lot more money for themselves. This was recently confirmed in a study[i] carried out by a group of three professors from Ohio State University and the University of Arizona.
In a paper accurately titled “The Performance of Hedge Fund Performance Fees,” the researchers studied the performance of nearly 6,000 hedge funds from 1995 to 2016. To remove the survivorship bias in the data, they made sure to include in their database all the funds that went out of business during the period under review. Interestingly, only 1,200 funds had survived at the end of the 22-year period.
Their findings are stunning: overall, fund managers kept 64% of the returns they produced in excess over LIBOR (LIBOR is an interbank short-term interest rate; ). Meanwhile, investors received only 36%. The aggregate excess return over LIBOR for all the hedge funds was 5.4% before fees. Of that amount, managers kept 3.4% and investors, 2%. In other words, managers retained most of the so-called “value-added” of the funds while leaving investors only crumbs.
There are several factors at play here. Hedge funds charge two types of fees: a base management fee, which is calculated as a percentage of assets under management; it is estimated at 1.5% in the current study. In addition, there is a second category known as “performance fees,” which are intended to motivate managers to maximize returns. This performance fee is calculated as a percentage of the fund’s value added beyond a benchmark such as the LIBOR index. The typical percentage that managers take away is 20%.
While the contractual performance fee of individual hedge funds is close to 20%, on an aggregate basis, managers collect almost 50% of the excess return over benchmark, after accounting for the base management fee. The reason for this is threefold. First, while the funds that perform well collect their 20% performance fee, those that underperform do not compensate investors for their poor performance. Performance fees are asymmetrical. A second factor is that investors tend to bail out after their hedge fund holdings have underperformed, thereby crystalizing their poor performance. And finally, underperforming hedge funds do experience high mortality rates which, once again, weigh on the collective performance of the hedge fund industry. An important detail is involved here: hedge fund performance fees are subject to a “high water mark.” In other words, a hedge fund that is at a loss cannot collect performance fees before fully recovering these losses. The high water mark is intended to protect investors, but it has a wrinkle: when a hedge fund goes way under water, it is incentivized to cease operations, since the likelihood of collecting performance fees again in the future becomes extremely low.
Overall, the gains from well-performing hedge funds are partially offset by the losses of underperforming ones, such that, on balance, the performance fees represent 49.6% of the gross return after accounting for the base management fee!
At the end of the day, hedge funds are complex and expensive products, and their performance fees encourage managers to take big risks to collect big dollars. If things don’t turn out well, their most lucrative option will be to shut down the fund and start a new one.
Traditionally, hedge funds were private investments reserved for wealthy investors. Today, however, they are much more accessible. There are at least half a dozen hedge fund ETFs in Canada and more than 20 in the United States.
In my opinion, investors are much better served with total market bond and equity ETFs that faithfully replicate the performance of global markets at low cost.
[i] Ben-David, I., Birru, J., Rossi, A., “The Performance of Hedge Fund Performance Fees,” Working paper, 2020
