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Wednesday, May 23, 2007

For my Hedge Fund Friends...

From the NY Times...

Last year, the Standard & Poor’s 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees, according to Hedge Fund Research in Chicago.

A little education on hedge funds for those not in the know, correct me if I'm wrong. They are different than mutal funds in that they can borrow capital to invest and are not as regulated as mutal funds. They also charge very large fees, typically 2% of what you invest plus 20% of your profit. Also, it takes alot of capital to buy into a hedge fund, these are for rich people. They can charge high fees because they can deliver high returns. Read the article and see how much some of the managers make, enough to run the National Park system. The rich get richer. Even better when you think about the US cutting capital gain taxes, so you can make this money tax free, and the option is not open to most of us.


angelq said...

Wow. What a great industry! These people get paid a butt-load of money for doing a mediocre job. And I love that the amount of money invested in hedge funds over the last four years has increased more than 60% - from $1 trillion to almost $1.5 trillion. Where is all this money coming from. I didn't realize Fort Knox was so big.

japruf said...

Alright, I'll take the bait...

First, the media is not adept enough to adequately describe hedge funds (or much of anything, but particularly this).

There is a point elsewhere in the same article pointing out that those are the average returns, and that actually the largest funds significantly outpace those figures. On the other hand, the idea of a hedge fund is to have stability, not large gains. So, getting between 5 and 15 % every year instead of losing some years. They can do this because they can also sell short and trade in all kinds of derivatives products that aren't open to mutual funds.

The other piece is that the biggest funds (the successful ones, see above/the article) aren't really even for rich people. They are mainly institutional investors, so actually, you do have exposure to them if your pension fund has invested in them. Think about it, because of the regulation involved in who is allowed to invest, it costs a good bit of time and money to sign up an investor, so if you have a $20B fund, you won't allow people in with the minimum gov't reg of $1M, because it isn't worth your time. $1M would be 0.005% of your portfolio, or a lot less than your daily volatility.

As to the why they make so much money: because they can, and this is good. Why is this good? What would you do if you won $20M in the lottery (after tax, blah blah)? I'd quit my job. So, if you want people to make the most money for you you can, and they already have a whole hell of a lot because of their talent for making money, then they'll just quit because they have more than enough already. The incentive to keep working (with serious risks of regulatory/legal problems with one misstep) has to be incredibly high.

On a more general positive, hedge funds really do make the markets more efficient, which is good for everyone. But, as they make markets more efficient, they make it harder for themselves to make money based on inefficiencies.

EE said...

I'll take the bait some too.

I think the basic point that hedge funds hedge, so sometimes they match a strong market (like last year), but over the long run, they outperform the market... is worth reiterating.

Institutional investors, like pension funds, universities, etc, don't invest as haphazardly as individuals, and they wouldn't be paying such enormous fees if they weren't worth it. It's annoying to all of us that some people are getting SO rich, but it's not quite fair to say they don't earn it. Sadly, I don't know how to write their algorithms.

An incredibly interesting side note is that as the hedge fund industry becomes more "mature" (ironic term), and there are more and more mediocre managers who don't really justify their fees... the more they resemble mutual fund managers!! Unlike hedge fund managers, who generally DO create value for their investors that is significantly more than the S&P, basically no mutual fund managers in history have ever created sustained value for their investors that is greater than the S&P. The fees they charge aren't as high, but there's a lot less point in paying them. It's a little telling that more rational and successful investors in the stock market (like hedge funds, among others) don't even give their employees the option of investing in mutual funds.

So while mutual fund managers' salaries aren't high enough to make huge headlines, they are high enough for these lucky people to live lovely lives, financed by skimming money off the top of not-so-rich people's savings, and lowering the value of not-so-rich people's net worth. This is very yucky.

And a brief note on capital gains - the real issue to pay attention to is not capital gains being cut, but the lack of taxes that are assessed on the HUGE amount of money made by private equity firm managers. PE is great for the US economy, but I think there's room to charge a lot more taxes on the top earnings.... and still leave plenty of incentive to do the work. We all pay a much higher tax margin on the income on our W2s than PE managers pay on the millions they make doing their jobs. It strikes me that something is awry. A subject for another blog.

Bubba said...

I don't think I disagree with Japruf or ee. But, what I found most interesting out of that article is that I'm making more with my no load Vanguard S&P 500 Roth IRA as I would investing in your average fancy hedge fund.

Another interesting note, years the market does good it is harder to do really good with hedge funds, because they ... drum roll ... hedge.

Captial gains should be taxed as income, period. Rich people should have to pay taxes too. I think we should go to a graduated flat tax, but I'm a progressive.