Saturday, December 27, 2008

The Bullish Case for Hedge Funds


By Eric Jackson

12/26/08 - 12:56 PM EST

The one group of investors that's been vilified more than any other by the business press and government officials alike in 2008? Hedge fund managers.

After years of rapid growth in terms of both assets and numbers of funds in operation, the hedge fund industry has taken a PR black eye this year. Media reports would have you believe that the industry is about to collapse in size, see its revenue drop dramatically through fee reductions and become heavily regulated to protect unsuspecting investors from another Bernie Madoff scam.

Hedge funds certainly make an easy target. They've had a bad year, along with every other retail and institutional investor. But the industry is about to grow dramatically over the next five years. This coming year will mark the beginning of the next wave of this industry's growth.

The 12 months of 2008 have proved an abysmal year, and every investor can't wait to be done with it. While hedge fund managers have done terribly, (with the exception of maybe Bill Miller) no one in the media seems to criticize the mutual fund managers or other wealth advisors for lousy performance.

It seems to be an unstated opinion in many articles that hedge fund managers should know better than other investors. One simple reason for this, a reason that draws endless attention and criticism, is hedge fund manager compensation. It's true that the best-performing fund managers over the last few years have been well compensated.

I don't have a problem if a hedge fund manager, the CEO of Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) or the head of risk management at Citigroup (C Quote - Cramer on C - Stock Picks) gets paid boatloads of compensation year in and year out, on two conditions: (1) they should only be paid well based on their direct contribution to the performance of their firms, and (2) that performance should be "real" performance, meaning that there is real value created, not some illusory accounting profit.

Hedge fund managers have an advantage over those who hold the types of positions mentioned above. First, as with a sales rep, you always know how a hedge fund manager is doing. With the exception of managers that dabble in private equity or illiquid assets, which are more difficult to manage on a daily mark-to-market basis, any hedge fund investor could get a daily report on how a manager is performing.

And hedge funds -- even the big ones -- are still small shops. If a fund has a good year or a bad year, its manager, whether it's Stevie Cohen or Bill Ackman, gets the credit or the blame. They don't get to punt responsibility to a foreign office or a snowstorm that kept away retail shoppers.

The second advantage hedge fund managers have over others when it comes to their compensation is that their performance is "real" at the end of each calendar year. Simply put, the market value of your portfolio this year gets measured against last year's market value.
Whether or not these profits were aided by leverage, hedge fund managers must perform in order to be compensated. While others can use their political skills to keep their jobs, hedge fund managers have to live with their fund's performance and the consequences that performance brings.

After a disastrous 2008, the big commercial banks are holding back recently injected capital from taxpayers to pay out year-end bonuses. However, few hedge funds (with the exception perhaps of the 10% that made money this year) will pay out bonuses.

What's more, many of the hedge funds that lost money for their investors this year adhere to "high-water marks." This means they have to make back their 2008 losses in 2009 before they are eligible for future bonuses. Investors get made whole and their managers only get bonuses when they actually deserve them. Citigroup investors sure wish they could get that kind of arrangement.

Hedge fund managers -- unlike mutual fund or other private wealth managers -- get paid for performance, not assets. Their incentives are perfectly aligned with their investors. They make calculated bets and expect to be highly compensated only when they succeed. This arrangement has attracted and will continue to attract talent. The best managers will migrate to hedge funds because they can be more successful financially.

They also accept the financial and reputational pain of performing poorly. Even with less leverage and more regulation, the hedge fund industry is still the best game in town for the most talented managers.

And it's also the best game in town for investors -- which is why the industry is set to begin its next wave of growth in the next five years. The most sophisticated investors still need help managing their money. They are not going to hoard Treasury bills forever.

Do you want to invest in a mutual fund manager incentivized to grow assets but not necessarily performance? Would you not, if you had the opportunity, want to invest in the best qualified money manager?

It's true that Bernie Madoff's Ponzi scheme has shaken the trust of investors in all money managers, and that will have a fallout effect on hedge fund managers. However, the hedge fund industry will be much bigger in 2013 than 2008.

Here are some other fearless predictions for the industry:

  • The number of hedge funds will decrease by 30% between the start of 2008 and the start of 2010, but the assets under management will actually increase as investors seek out the best managers.
  • This growth will come at the expense of the mutual fund industry and wealth management.
  • The due diligence industry, which researches hedge funds and their managers, will quadruple in size. Today, there are few firms with expertise in this area (Due Diligence Consulting, Kroll and Backtracks are on a short-list of firms with expertise in this area). Investors will need to invest in hedge funds, but won't be able to rely on the Securities and Exchange Commission to conduct their due diligence. They won't mind paying for this work themselves.
  • The "2 and 20" fee structure for the industry (under which hedge funds charge 2% annually for management fees and 20% for the share of the profits created) will persist. Investors will not object as long as they receive the performance they expect.
  • Fund-of-hedge-funds will be most negatively affected by 2008. Larger institutional investors will become much more hesitant to invest in fund-of-hedge-funds over the next two years in the wake of the Madoff scandal for fear of criticism from their own investors. These types of funds will not go away, but there will only be so many people that can say, "I can get you into John Paulson's fund."
  • There will be more hedge fund regulation from Washington but not to the extent that it kills the industry. What purpose would that serve the Obama administration? A greater administrative burden dealing with new regulation will become the new cost of doing business for hedge funds. It will make it harder for newer/smaller hedge funds.
  • Hedge fund managers will become better risk managers and learn to perform without the benefit of leverage. Those with enduring strategies that can create value will grow.

Hedge funds are not going away. They're actually going to greatly increase in size over the next five years. The level of dissatisfaction in mutual fund managers and private wealth managers will cause investors to seek out better-performing investment vehicles for their cash. Although there will certainly be changes to the industry as a result of the events of 2008 -- including hedge fund failures in the next six months -- the future looks very bright for hedge fund managers and their investors because their interests are so well-aligned.

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