Hedge fund fees and lousy performance were a big theme at last week’s SALT Conference in Las Vegas. Most reports made a big fuss over the possibility of meaningful change. My take? Don’t bet on it.
Fees may come down incrementally. But they have been baked into the industry’s culture for so long that there is a sense of entitlement among those who have been in the business for decades, while they are the lure for those just getting into it.
The reality is the fee structure — now roughly 1.5 percent of assets under management and nearly 18 percent of performance, according to industry tracker HFR — was created during a different era, when hedge funds were a totally different product. Today the fee structure has become one of the biggest legal scams in this country, along with the time-share industry, and shows little chance of changing significantly.
Here’s why. In the 1980s and 1990s, when hedge funds started to get noticed, the average fees were 1 percent for the management fee and 20 percent for performance. Some hedge funds charged even more. The idea was that the 1 percent would pay the costs of running the fund, and then everyone would reap their share of the performance. At the time, there were not many hedge funds, and they were barely regulated. There also were very few journalists following them.
Hedge funds enjoyed a certain mystique because they had a reputation for posting outsize returns. That was their brand and the justification for the fees. A number of hedge funds posted annual returns that were two, three, four and even five times what traditional investment managers were generating.
So investors — mostly high-net-worth individuals at the time — were happy to pay the hefty fees, explaining they cared only about net returns. And who could blame them? Hedge funds were making them much, much richer.
For example, Tudor Investment Corp. founder Paul Tudor Jones II established his reputation posting a 201 percent gain — that’s not a typo — after correctly predicting the stock market’s October 1987 crash. You think his investors cared that over the years he charged a 4 percent management fee and 23 percent of performance?
In the 1980s and 1990s, three firms were the face of the hedge fund industry: George Soros’ Soros Fund Management, Julian Robertson Jr.’s Tiger Management Corp. and Michael Steinhardt’s Steinhardt Partners. Soros posted annual gains between roughly 30 percent and 70 percent in every year but one from 1989 through 1995. During about the same period, Robertson posted gains between roughly 21 percent and 61 percent for six straight years, and in 1996 and 1997, he posted gains of roughly 40 percent and 57 percent, respectively. In the 1980s and 1990s, Steinhardt posted double-digit gains virtually every year ranging between mid-20 percent and more than 50 percent. All three hedge fund icons charged just 1 and 20, a relative bargain compared to many inferior managers today.
Investors were willing to give SAC Capital Advisors’ Steven Cohen a 3 percent management fee and half their gains, which he justified when he posted roughly 70 percent net returns in both 1999, the top of the Internet bubble, and 2000, when the bubble burst. His main fund had compounded at about 30 percent annually by the time the government shut him down in 2013. It had compounded at 35 percent annually through 2007.
In the late 1980s and 1990s, many others were posting big gains as well. They include now retired CTA legend Monroe Trout of Trout Trading Management Co., who posted gains of 20 percent to 60 percent almost every year. This was net of a 4 percent management fee and 22 percent performance fee.
Macro legend Bruce Kovner generated 28 percent annualized gains in the first 20 or so years after he launched his firm, Caxton Associates, in March 1983 after spending five years at the legendary Commodities Corp. In 1987 he racked up more than 90 percent returns in his two funds, and through 2002 Caxton’s funds enjoyed double-digit gains in all but two of their full years of existence. Investors didn’t mind, then, that Kovner was charging 2 percent of assets under management and a 25 percent performance fee.
You get the pattern.
In November 2002, Kovner raised his management fee to 3 percent of assets and his performance fee to 30 percent. However, by then the industry was already changing. Steinhardt closed his fund in 1995. Trout retired in 2002 at the age of 40. Robertson closed down his Tiger funds in 2000 after posting sizable losses when he failed to embrace the Internet boom.
Meanwhile, by the new millennium, the hedge fund industry enjoyed a surge in new capital as the number of new funds grew exponentially. Many of the new generation of managers were displaced from their Wall Street jobs following the dot-com bust and lured by the huge sums of money that hedge fund managers were making. Suddenly, managers who were already making big gains from exploiting inefficient markets found themselves with a lot of company. Performance returns started to decline sharply.
In a 2008 interview, Kovner — who posted average annual gains of only 8 percent in his final nine years before retiring at the end of 2011 — conceded that he heavily benefited in his early years from a dearth of competition. He added that the tremendous amount of money that later flowed into hedge funds made it more difficult than ever to exploit inefficiencies.
“The crowded nature of the hedge fund community has changed the character of trading so that you can see waves of risk-taking and derisking coming from the hedge funds themselves,” he explained. “When there were ten or 15 very active hedge funds, it didn’t matter what they did. When there are 10,000 hedge funds, it does matter. They move the markets. In addition, market opportunities get arbitraged out somewhat. Fifteen years ago, I might have traded some things that we don’t trade at all now.”
Meanwhile, institutions were starting to become much bigger investors in hedge funds. And they were not as concerned about making the last percentage point. They had to answer to their boards of directors and started to settle for lower returns as long as the funds took less risk. Suddenly, “absolute returns” and “risk-adjusted returns” became the favored mantras. No one was touting “outsize returns.”
At that point, many of the early gunslingers were growing older and had amassed huge amounts of wealth, which they preferred to preserve rather than risk wildly.
“Clients these days don’t want you to take risk with their capital,” Highbridge Capital Management co-founder Glenn Dubin told me in 2010 when I did a profile of his friend Paul Tudor Jones II. “Great pools of wealth — sovereign wealth funds, ultrawealthy family offices — don’t need to see 30 percent returns every year. In the case of Tudor, they want to know their capital is safe and that the steward of their capital is one of the greatest traders of all times.”
Well, as they say, be careful what you wish for. From 2011 through 2015, Jones has posted low- to mid-single-digit returns in four of those years, the only outlier being 2013, when he was up 14 percent.
Fees, however, remained the same or rose, to 2 percent of total assets. The management fee suddenly became a profit source for many firms that obsessively focused on growing their asset base. Meanwhile, a 2 and 20 structure heavily cuts into the gains of the investor when performance is very low. for example, if a fund were up just 6 or 7 percent gross, these two fees would roughly halve that return on a net basis.
What will change the fee structure? Well, clearly not consistent underperformance, as the past seven years show.
Sure, some big investors have been playing hardball with hedge funds, such as the New Jersey Division of Investment. It regularly requires hedge fund firms to give them a better deal than most other investors get. However, it has about $80 billion in assets, so it can throw its weight around.
A person who works for a much smaller state investment fund recently told me that the fund tried to get a few major big-name firms to cut them a better deal but to no avail. And an investor with less than $500 million laments to me he doesn’t have the clout to even ask.?Perhaps even more bad performance will finally move the needle. It was recently reported that Tudor suffered about $1 billion in redemptions. Leon Cooperman’s Omega Advisors suffered about $2 billion in redemptions last year.
However, for there to be meaningful change, the industry needs to be hit by a disruptive force — something like what has happened to retail and other industries, as well as politics. Maybe it will be a major hedge fund firm that leads the charge, but don’t count on it. They are not exactly going to stop charging a performance fee.
But you may see a major firm announce the institution of some sort of hurdle on every fund for every investor. This could put enormous pressure on other consistently underperforming funds. Adage Capital Management, which routinely ranks near the top of our annual Hedge Fund Report Card ranking, charges a hurdle and also gives back some of the previous year’s fees if it doesn’t meet its benchmark in a given year. But it is the exception, not the rule.
The likelihood is that outside some more trimming of fees, not much will change over the years, especially if hedge funds start to post a few decent quarters again.
As for the time-shares, well, that’s a rant for another time.
