Hedge Hog "Hogwash" — Part II: What they do

Chris Clair’s rebuttal of my questioning the compensation and worth of hedge fund managers continues.

For those who would like to follow the thread back to its Red Electric origins, my initial post, which invited Chris to comment, is here.

Part I of his response is here. I'll post Part III later in the week.

Note: Chris, a friend, journalist and former student, has reported on the hedge fund industry for the past eight years. He lives and works in Chicago and is the managing editor of Reuters HedgeWorld.


PART II

So what are hedge fund managers doing to earn positive returns? The best and brightest hedge fund managers exploit price inefficiencies in the market. They bet against securities (stocks, bonds and their derivatives) they believe are overvalued and buy securities they believe are underpriced or that have growth potential. Different managers do this in different ways and employ varying degrees of risk. Some funds are very low-risk and are designed to provide steady, incremental returns – say, 10% to 15% per year – in all market conditions (whether stocks are way up, way down or flat). Some funds use lots of leverage (borrowed money) to increase returns, or trade in complex securities that few understand, thereby raising the level of risk. The type of strategy any particular hedge fund follows and its riskiness is outlined in its offering documents.

Speaking of offering documents, I have to digress for a second here to talk about the “gambling” issue. Rick, you wrote, “Then there’s the question of whether the top 25 actually did anything to “earn” their largesse besides gamble with other people’s money.” Hedge funds invest money on behalf of other investors, but most hedge fund managers also place their own money in the funds they manage. In fact, outside investors often won’t even consider a relationship with a hedge fund manager that does not place a substantial amount of his or her own net worth in the funds that manager runs. It’s about alignment of interests. So while the managers are investing other people’s money, they are also investing their own money.

Additionally, it's not like the hedge fund managers stole the money they invest from somewhere; when the system works correctly, investors conduct extensive due diligence on managers and make a careful and conscious decision to gamble their own money. It's up to the investor to understand what he or she is investing in. Caveat emptor!

If one wants a risk-free investment, one should buy Treasury bills or open a savings account. Historically - like over the past 100 years – stocks have returned about 11% annually and bonds something less than that. When you experience years like we had in the 90s, (between 1990 and 1999 the average annual return of the U.S. stock market was nearly double what it was from 1926 through 1999), and the same in the middle part of this decade, you can bet there's going to be a reversion to the mean. In other words, people who got in at the end are going to lose money, at least in the short term.

Instead we seem to keep buying into the notion that every time we enter a bull market, it's a "new paradigm" and the "old rules" don't apply. That's just stupidity. So of course any investment in the stock market or anything else (even Treasuries when you get right down to it) carries the risk of loss. Hell, stuffing money in your mattress carries the risk of loss (fire, flood) but without any possibility of earning a positive return.

The hedge fund manager’s job is to earn money in all markets – to be smart enough to avail himself or herself of all the investment tools at his or her disposal to earn investors a positive return no matter what. Historically, the good ones have done that, which is why they can get away with charging higher fees. In the process they have helped boost university endowment returns and protected workers’ pensions. Even last year, the worst year on record for hedge funds (the average fund was down 19%) they still performed only half as bad as the stock market. And since the bulk of a hedge fund manager’s compensation comes from the performance fee, when a hedge fund manager loses money he gives up most of his or her income. And not just for that year, either. Most hedge funds have what are known as “high water marks,” whereby the manager must make up all that he has lost and then some before he can begin collecting the performance fee again. After 2008’s debacle, some hedge fund managers may not collect performance fees this year or next year.

I make that point simply to illustrate that not all hedge fund managers are John Paulson or George Soros, that some of them are essentially small businessmen and that they also face the same risk of loss as their investors.