Simons, Griffin, Lampert, Soros, Cohen, Kovner
Dan Gross Has a Book Coming Out

Hedge Funds: Two-and-Twenty

The list of top ten hedge-fund earners for 2006 includes three people who I guess to be turnaround specialists and "industrial statesmen"--management entrepreneurs building or fixing organizations a la Andy Carnegie or Johnny Rockefeller or Charlie Coster of a century ago--Icahn of Icahn, Lampert of Sears, and Tepper of Appaloosa. It includes three people who I guess to be primarily wholesale bankers--Griffin of Citadel, Jones of Tudor, and Kovner of Caxton--making money through financial intermediation: taking on relatively long-term or securitized risk and hoping to God their information about the true value of those risks is better than the market's and that they are properly diversified. It includes two people who I guess to be primarily speculators--one high-tech and quantitative, Simons, and one lower-tech and judgment-based, Soros. And it includes two people--Cohen of SAC and Barakett of Atticus--about whom I am basically clueless about what they are doing.

Their high fees may be best conceptualized as a gap between book and market value: if they were publicly-traded corporations, you would have to buy into the stock of their organizations at a premium to book value. The hedge fund form, however, allows you to buy in at book value--minus fees. And the premium between book and market is then captured not (as it is in a public corporation) by all the previous equity investors, but just by the first initial tier.

Why this particular hedge-fund form of organization has risen to the top of the barrel right now is an interesting question. But it is clear that at the top we have people and organizations either with real skills and real edges operating at the financial economy's pressure points and adding mammoth long-run organizational and intermediational value--or people taking on huge adverse tail risks in hard-to-assess ways who have so far been lucky. It's hard to tell the difference.

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

Suddenly, Hedge Fund Fees Seem High: Steve Rosenbush: The top-performing hedge funds and private equity firms have generated annual returns in excess of 50% during the last few years.... Now some institutional investors have started to complain, noting that the average hedge fund failed to keep pace with the market in 2006.... CalPERS Chief Investment Officer Russell Read said many hedge funds charge too much without delivering high enough returns or low enough risk. "We have no problem paying high-performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," Read told attendees at the Geneva conference.... A hedge fund typically charges investors a management fee of 1.5% to 2%, and takes 15% to 20% of profits the fund generates. An index fund's management fee, by contrast, is typically just hundredths of 1%. The prominent Vanguard 500 Index Fund (VFINX) has an expense ratio of just 0.18%, for example....

[I]n 2006... CalPERS... $4.3 billion in hedge fund investments generated a return of 13.4% for the year. That was slightly ahead of the average hedge fund return of 13%, but just below the 13.6% return the Standard & Poor's 500-stock index generated in 2006....

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

Investment banks such as Goldman Sachs (GS), Merrill Lynch (MER), and Morgan Stanley (MS) have introduced lower-priced investment vehicles that may compete for some hedge fund business. Goldman, for example, introduced a product in Europe last fall called the Absolute Return Tracker... "expected to display returns over time that resemble some of the patterns of hedge funds as a broad asset class."... [S]ome private equity shops are trimming fees as a response to the sheer size of many new funds. The Blackstone Group, which is in the process of issuing about $4 billion worth of stock in its management company to the public, charges a management fee closer to 1%, industry experts say...

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.