3
The Outer Limits: Hedge Fund Fees
Now we come at last to the crowning achievement of the fee-charging business, the pièce de résistance, the masters of the fee-charging universe—hedge funds.
Hedge funds, like mutual funds, are pools of commingled investments shared among multiple investors. The difference between mutual funds and hedge funds is that hedge funds must restrict the type and number of investors that invest in them. Investors must be wealthy enough to bear significant loss (they must own at least a million dollars in investment assets or have income of at least $200,000 a year). As long as a hedge fund adheres to the restrictions on the type and number of investors, it escapes regulations applying to mutual funds. In particular, hedge funds can charge differently structured, higher fees, and they can use “leverage”—they can borrow to invest and use derivative investments mutual funds cannot use. They also don’t need to make their numbers public or have them audited. The principle is that because the investors are wealthy and “sophisticated,” they don’t need the government regulatory structure to protect them.
A typical mutual fund, as we have seen, charges 1.5 percent of assets, plus brokerage commissions of perhaps a 0.5 percent. Given that an index fund product charging you 0.1 percent of assets—about one-twentieth as much as the typical mutual fund—is just as good or better, this is a pretty hefty fee.
But compared with hedge funds, mutual funds are real pikers.
Let’s Do the Math
Hedge funds typically charge 1 to 2 percent of assets, plus a “performance incentive” fee of 20 percent of gains—though they can go as high as 4 percent plus 44 percent of gains. Sometimes there are additional administrative charges of about 0.5 percent.
For the sake of example, let’s assume a hedge fund charges 1.5 percent fees plus a 20 percent performance incentive.
If the fund performs approximately like the long-term stock market—roughly 10 percent per year on average (and that, incidentally, would be good for a hedge fund)—then you would think the hedge fund manager gets 20 percent of that 10 percent, or 2 percent, as the performance incentive fee.
But, no, that’s not quite the way it works. Returns fluctuate widely from year to year. Let’s suppose the manager gets an annual 10 percent return over a two-year period but gets it by gaining 60 percent the first year and then losing 25 percent the second (that compounds to about 10 percent annually, on average).
Hence, the manager gets 12 percent for the first year—20 percent of 60 percent—and nothing for the second year, for an average of 6 percent a year. Not bad! That, plus the 1.5 percent base fee is a fee of 7.5 percent per year, on a return of 10 percent per year, leaving 2.5 percent for the investors—one-third as much as the manager gets.
Let’s try this again with some real dollar numbers. You’re a high roller like most hedge fund investors, so you’ve put a million dollars in this fund. In the first year your hopes are realized. The fund goes up 60 percent!
Now you’ve got $1.6 million—a whopping gain of $600,000. But you’ve got to pay the fees: 1.5 percent of assets plus 20 percent of gains. One and a half percent of $1.6 million is $24,000, and 20 percent of the $600,000 gain is $120,000. So you pay the hedge fund manager $144,000—that is, $24,000 plus $120,000. But you don’t mind, because the manager’s skill (or so you think—of course, it might have been just luck) has made you $456,000 after fees.
But in the next year the manager’s skill fails her—or perhaps she just encounters bad luck—and the fund loses 25 percent of its assets. You had $1,456,000 after fees at the end of the first year, so at the end of the second year you have 25 percent less, leaving you with $1,092,000. But now you have to pay the 1.5 percent management fee, which on $1,092,000 is $16,380, leaving you with $1,075,620.
Over the two years, you’ve realized a gain of $75,620 on your $1 million while the manager received fees of $156,380, more than twice as much as you earned.41
The Highest-Paid Business in the World
This anecdotal estimate is corroborated by the actual dollars paid hedge fund managers and their brokers. In 2004, those fees totaled $70 billion on an estimated $1 trillion in hedge fund assets—an average fee rate of 7 percent.1 And that doesn’t include an additional layer of “funds of funds” fees, to which I shall come shortly.
While not all hedge funds have large ups and downs, the ones that acquire the big names, essentially carrying the whole hedge fund business in the public mystique, do experience large ups and downs. They get famous for the ups and draw huge amounts of investment capital and then are usually not noticed so much for the downs. But the hedge fund managers make out very well on them.
Where are the investors’ yachts? Indeed, where are the investors’ flotillas? Hedge fund management is not just a license to steal; it is a license to steal literally billions. The hedge fund management business has created more billionaires than you can shake a stick at. In 2004, according to Alpha magazine, a magazine published by Institutional Investor, the average cash take-home pay for each of the top twenty-five hedge fund managers was $251 million.2 Yes, you read that right. It doesn’t take long to become a billionaire at that rate. And where does the money come from? It comes literally straight out of the investors’ accounts.
Hedge Fund Celebrities
One of the controversial celebrities of the hedge fund business is George Soros, who, with Jim Rogers, started the Quantum Fund in the late 1960s. For a period of time it had outstanding returns, though later it busted so badly that it shut down. So how did Soros and the investors make out?
It’s very difficult in most cases to know exactly how a hedge fund performed, because information is not public, numbers are only estimated by fund management itself, and numbers are not audited. I’ll take up the question of hedge fund performance in another chapter. But we can get a rough idea, in the case of Soros’s fund, of the relative return to investors and to management.42
Appearing in the October 18, 2004, issue of The New Yorker was a mostly positive article about Soros’s foray into politics in that year, written by the seasoned journalist Jane Mayer.3 Anyone who can do simple arithmetic should find a revealing nugget of information embedded in Mayer’s story.
Soros’s wealth is attributable mainly to his management of the Quantum Fund, one of the earliest and most famous hedge funds. According to the article, Soros’s wealth is estimated at $7.2 billion, on top of which he has given away more than $4 billion, for a total of more than $11 billion.
As to the source of Soros’s wealth, according to Mayer: “The [Quantum] fund, which is registered in the Netherlands Antilles, turned an original investment of six million dollars, in 1969, into five and a half billion dollars by 1999.”
Hence, Soros personally amassed over $11 billion while the fund amassed $5.5 billion. Of the fund’s growth, we can rest assured that a large part of it, probably most, is due to the entry of new investors and their money, not to growth of the investors’ assets itself.
The inevitable conclusion is that Soros himself earned at least twice as much as the investors, and probably a much greater multiple.
None of this is intended in any way to detract from Soros, who ranks among the great philanthropists of all time, especially for his work in formerly communist Eastern Europe. But the investors in his hedge fund may or may not feel proud to know that of their investment returns, two-thirds, at the very least, went to enrich the fund manager and as donations to socially responsible projects, while at most one-third went to themselves.
You would think that given the enormous amounts of money wealthy hedge fund investors pay out of their accounts to make billionaires of hedge fund managers, they would be extremely careful to research whether they are receiving equivalent value. Are they extremely careful? Not really. They might look, unscientifically, into the historical results of a fund they invest in—if results are even available. But do they evaluate in any serious way whether those results were due to skill or sheer luck, and whether there’s any likelihood those results will continue? No, they don’t.
One unique case of a hedge fund that won more fame in the public eye for its major down than for its ups was Long-Term Capital Management (LTCM), of which I will say more later. After a period of several years of soaring returns—convincing many investors that those returns would continue forever—it encountered a decline so disastrous that it was effectively bankrupt, endangering several mammoth banks that had loaned it huge amounts of money. In the eyes of the U.S. Federal Reserve, its failure could have threatened the whole financial system if action were not taken. LTCM wound up being owned by the banks that loaned it money and recovered—essentially as a different company—but many of its investors did not.43
No Bounds on the Ability to Charge Fees!
One problem that was noticed about performance incentive fees early on is that they create an incentive for highly fluctuating returns. As I showed, the performance incentive fee is much greater if the fund gets its return by experiencing huge ups and downs than by getting a steady annual return.
What performance incentive fees do for you is essentially give someone else the right to gamble with your money—and to collect a 20 percent fee when they win, while sticking you with all the losses when they lose (and collecting a 1 or 2 percent “administrative fee” into the bargain, whether they win or lose).
Yet getting a steady annual return—that is, avoiding the downs—is supposed to be one of the selling points of hedge funds (the very name itself—hedge funds—suggests that they hedge against downside risk).
To avoid creating this incentive to take on extra risk and volatility, the hedge fund industry introduced another feature in the fee structure: the high-water mark. With this feature in place, the manager can’t get a performance fee in an up year if it wasn’t sufficient to recover from a previous down—that is, if it didn’t surpass the high-water mark created by the previous high.
For example, in the five years 1999–2003, the stock market as a whole (as represented by the S&P 500 index) gained 21 percent in 1999, lost 9 percent in 2000, lost 12 percent in 2001, lost 22 percent in 2002, and then regained 29 percent in 2003. If a hedge fund manager got those returns, she would have received her 20 percent performance incentive fee in 1999, but not in 2003, because 2003’s 29+ percent was not enough to recover from the downs of 2000–2002. This is a sensible provision that helps rein in some of the worst potential excesses (as if the less-than-worst ones weren’t bad enough).44
Yet some of the newest breed of successful (they have the yachts) hedge fund managers are trying to sidestep that requirement. “No bounds on my ability to charge fees!” they say. An insider newsletter of the hedge fund industry, Hedge Fund Intelligence—not a place where the whistle will ever be blown on the entire industry, but a place where you might find a smidgen of self-criticism—published this report:
Setting the fees… and the high-water mark used to be a relatively simple task. The fees were typically a management fee of 1%–1.5% and a performance fee of 20%.… And there was always a high-water mark above which a fund had to rise before performance fees were payable. Today, it is far more complex.
A group of “hot” start-up managers have started to challenge the norm by setting aggressive fees… and scrapping the high-water mark in favor of a more flexible structure.…
In some cases, there are good business reasons for these changes. But, more often than not, the trend is happening because some new managers have decided to charge whatever they think they can get away with.…
In a recent case David Ganek, formerly with SAC, started the Level Global fund with an 18-month lock-up and a performance fee that moves up from the standard 20% to 30% when performance rises over 5%. He also scrapped the high-water mark in favor of a scheme that allows a manager to get a lower performance fee once the fund starts to recover from a drawdown. And he got away with it, raising significant sums of money on day one.
His move to scrap the typical high-water mark was particularly innovative and borrowed from Steve Mandel at Lone Pine Capital. The way it works at Lone Pine is that the fund can charge half of the performance fee of any gain the fund makes from its low. This 10% performance fee continues until the fund has made up 150% of the drawdown from the previous high. Then the standard 20% fee kicks in again.4
OK, now do you understand hedge fund performance fees? The more complicated it is and the less investors understand the fee structure, the more you can charge.45
Besides, if you find yourself submerged below a high-water mark and can’t charge fees, hey, no problem! If your reputation as a bell ringer still lingers from some past year, then Allacazam! All you have to do is close your fund and open a new one. Then you can start charging fees again as if you had never fallen below the high-water mark.
The High Rollers Connive in Their Own Fleecing
So why do investors invest in these funds? And they are generally very wealthy investors, the kind who are supposed to be “sophisticated.” Why do they do it?
Simple—it’s the Big Investment Lie. They do it because they think they’ll make more money by investing in these funds—or, at the very least, they think people will think they’re making more money in these funds. People are vain—especially many wealthy people. Appearing to be a high roller can be more important than actually making money. But mostly it’s just because investing in hedge funds is what their friends or associates told them to do—it’s all part of the Big Investment Lie. It’s all around them; they’re enveloped by it. Suggestions that it is quite simply dead wrong do not wake them up but only confuse them. How could all those wealthy and respectable people be wrong?
Besides that, investors like the Big Investment Lie. They want to believe it. They collude in it themselves. They hire advisors who help them believe it. They want to get rich quick—or if they are already rich, they want to get fabulously rich—and they’ll pay through the nose to someone who supports the belief that they can do it.
Funds of Funds
You may think we’ve now seen the absolute extreme, the outer limits, of fee charging. But oh, no! You haven’t seen anything yet. As if hedge fund fees weren’t high enough, an idea comes along to charge yet another layer of fees. Yes, some absolutely brilliant fee chargers created the “fund of hedge funds.” Funds of funds often charge in excess of an additional 3 percent of assets and—would you believe—an additional performance fee… and even a front-end load! All this is on top of the already outlandishly excessive fees of the underlying hedge funds.46
Funds of hedge funds, they claim, are for the purpose of diversifying away the risk of any one hedge fund. This is sheer nonsense because the use of hedge funds in the first place is supposed to be either to take a little extra risk with a small part of your fortune or to entrust a part of your fortune to a fundamentally conservative fund that demonstrably takes little risk by hedging against it.
Another purpose of funds of funds is to wrap hedge funds in a mutual fund–like instrument so that possibly smaller investors—those who aren’t so wealthy—might invest in it, with lower minimum investments. But the legality of this idea has not been well tested yet. With the increased regulatory scrutiny hedge funds are getting, it is not likely that this avenue will go far.
That’s all right, though, hedge fund and fund of fund managers are doing just fine living off the gullible rich.
Caveat Emptor: Let the Buyer Beware!
Much of what drives the investment advice and management industry is fees. This is not surprising. Business is first and foremost about collecting revenue. Without revenue businesses cannot survive, let alone thrive. Delivering a good product is important of course, but it can’t be delivered unless fees are adequate to maintain the business. So thinking about how to collect, maintain, and increase fees comes first in business, even before thinking about how to improve the product, even how to make a good product.
But often—especially if the customer seems reasonably satisfied—thinking about how to get and increase fees completely replaces consideration of whether the product is any good or not. I’ve been in the thick of the business—and I know.
Strategy discussions about how to enhance revenue become the be-all and end-all. Discussions about how to ensure or improve the quality of the product or service don’t take place at all, or they take place only in the context of how to retain revenue. This happens subtly, within a groupthink environment. It often doesn’t occur to employees—except perhaps peripherally or in joking over drinks after work—that their product, to use the colloquial idiom of the after-work drinking environment, sucks. If the customer continues to pay, the product is de facto assumed to be what the customer, however ill informed, misinformed, misled, flat-out lied to, or simply stupid, actually wants.47
Most employees continue to believe their own projected public image, that they are high-minded businesspeople performing a service that is—at the very least—worth the high level of compensation they are paid. If some employee pipes up and says something like, “Shouldn’t we be trying to do things that actually benefit the customer?” others eye that employee with a look of bewilderment, as if they don’t quite understand what he or she is saying.
Virtually the only check on this inexorable process is awareness on the part of the customer. In some professions, such as the medical and pharmaceutical fields, rigorous professional standards and government and industry regulatory bodies also provide something of a check. But in many fields, industry regulatory bodies are frequently handmaidens of the big players in the industry. Government regulatory bodies are often themselves “captured”—to use the economists’ term—by the industry, because of the steady flow of employees back and forth between industry and government.
The agency that regulates the investment services industry in the United States, the SEC, does an excellent job within its mandate. It does not, however, have—nor perhaps should it have—as broad a mandate as do some other regulatory agencies. For example, the FDA has the authority to determine whether a new pharmaceutical drug performs better than a placebo before it will approve it for sale to the public.
The Corruption of Information
Governments and government regulatory bodies cannot wholly protect customers from themselves. They cannot protect them from being adamantly or willfully misinformed or from making bad choices.
In the end, the only true check is a sufficiency of information in the hands of the customer, enabling the customer to make a good decision. The customer must, therefore, find good sources of information, weigh them against each other, and make intelligent choices.
The companies themselves, trying to sell the customer investment services are, of course, one source of information. This source, however, as we have seen, is biased and suspect, because of the self-interest of the companies. The customer nonetheless has a tendency to weight this source too heavily because of what the customer believes to be the respected names of the companies. Because of the Big Investment Lie effect—the belief that it is surely impossible for so many authority figures to support an out-and-out bald lie—the customer tends to disbelieve information that flatly contradicts facts stated or implied by these highly respected brand-name firms.48
The truly diligent customer will seek out unbiased sources like watchdog organizations, financial media, and academic studies. And many of these sources do provide accurate and unflinchingly truthful information. But many—probably the majority—put out information that is itself heavily tinged with the Big Investment Lie. Even the financial media and the academic financial community have been, by and large, subtly co-opted by the Big Investment Lie and the lure of money.
The co-option is the same as—if once removed from—the process whereby corporations begin to think only about what to tell customers in order to collect revenue and less about whether what they are saying is correct.
In the case of financial journalists and academicians, the incentive is not so much that they must earn revenue to maintain their businesses. The incentive is, rather, the possibility that the fabulously large levels of wealth accruing to so many people in the business could some day, somehow, come their way. To the extent that they stay in good graces with the investment services industry—parroting or at least not uncloaking too revealingly the Big Investment Lie—there is the chance they might join the party.
This happens frequently to academicians in the financial field. If an academician makes a name for him- or herself in academia and is not too much of a boat rocker, the academician could pull down a plum of a side job. Some are asked to become mutual fund trustees, with compensations well above half a million dollars a year—for doing very little. Some become money management or hedge fund consultants or even partners, with compensations potentially in the untold millions.
It is quite common for two professors to hold neighboring offices, one having lucked into a consultancy or partnership in an investment management firm that brings her millions, the other still subsisting on a meager academic salary, while keeping a constant lookout with envy, greed, and longing for his big chance. Is either one likely to become a whistle-blower and proclaim loudly that the whole industry thrives on a Big Lie? Not likely. Not when there are such big payoffs in the offing.49
True, many important voices in the academic financial field do clearly speak the truth. Notable, among others, is distinguished Princeton professor Burton Malkiel, author of the best-selling book A Random Walk Down Wall Street. But many have been co-opted or remain silent—except among their peers—thus rendering their profession incapable of forming a strong counterforce to combat the Big Investment Lie.
The same is true of the financial journalism profession. Not only may financial journalists endanger their access to insiders and their ad revenues from the financial industry, but they might also endanger the possibility, however slim, that some day, in some way, they could themselves be cut in. Besides that, much of the financial journalism profession seems itself to be taken in by the Big Investment Lie. As Tom Gardner of “The Motley Fool” said when the Beardstown Ladies were exposed by the media as “frauds,” “we haven’t yet come across a single article entitled ‘Mutual Fund Managers Called Frauds.’” Why not? Because the investment management industry’s slick and polished methods keep the Big Investment Lie afloat, while the much more naive (and ethical) Beardstown Ladies could not even tread water once their own little inadvertent lie was revealed.
Although there are notable, laudable exceptions—Forbes magazine’s consistent exposure of the absurdly high fees, sleaziness, and pointlessness of hedge funds is one outstanding example; The Economist’s consistent skepticism about them is another—most financial coverage in the media gives the impression that everything, save for the occasional fraud case, is on the up-and-up. You would never know from the vast majority of media stories that the whole thing is shot through and through with a Big Lie.