Hedge Fund Math: Heads We Win, Tails You Lose | Hacker News Reader

Hedge Fund Math: Heads We Win, Tails You Lose

nytimes.com

248 pointsJumpCrisscross117 comments

Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark? One of the common memes of investing over the last few decades is that no one can reliably beat the market. It's very easy to use an index fund to track the market at very low cost. If I invest in an actively managed fund I want them to be compensated for doing better than I could have done myself.

There are a few advantages to this, in my eyes:

1. They only get compensated for their value, not the rising of the economy. It's terrible for the investor to have an economy that's going bonkers and the hedge fund that's taking 20% of that while not providing their own value. You could easily be doing worse after fees. 2. It incentivises managers to figure out ways to avoid losses. If the market drops 10% in a year, but the fund only drops 5%, treat it similarly to a profit of 5% because that's the value the hedge fund provided.

Looking at any investment gains in isolation is outdated. Investing is easier than ever for the layperson. We need to start looking at the opportunity costs.

> Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark?

They usually (EDIT: sometimes) are. The 20% is typically (EDIT: has been in my recent experience) measured against a benchmark. The trick, however, is in selecting and/or constructing that benchmark. There are also as many definitions of alpha as there are hedge funds.

"They usually are. The 20% is typically measured against a benchmark. "

That is incorrect. The 20% refers to a fund management performance fee equal to 20% of all profits (without reference to any benchmark index). However, there is usually a "hurdle rate," like 5%, so 20% refers to 20% of all profits above the hurdle rate. There is also a "high water mark," so that past losses are counted against any "profits" to which the performance fee is applied.

"Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark?"

This is called a "relative return" strategy. Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

Hedge funds generally claim that they aim to achieve a positive return on investment regardless of whether markets are rising or falling (i.e. "absolute return strategy"). In theory, this means that hedge funds should have low correlation with the benchmark. This low correlation is attractive to investors because it provides a diversification benefit and (in theory) improves their efficient frontier. Low (or ideally zero) correlation to the benchmark is the main reason that institutional investors are willing to pay expensive hedge funds fees. However, if hedge fund managers have incentives based on relative returns to the benchmark, then hedge funds will be more correlated to the benchmark.

I'm asking for my edification, rather that putting forward a line of argument, but assuming for a moment that the trades are not so large as to have a direct impact on the market, there would appear to be a great deal of hindsight information available upon which to build a benchmark.

A hedge fund appears to be an investment strategy that compensates for having imperfect information. Why is it not possible to estimate an alpha on the range between the results of a completely naive Monte Carlo simulation ("no information") and the results of a search for the optimal hindsight strategy ("perfect information")? That is, the payoff for the manager will be fixed and proportional to the fraction of hindsight performance that he achieves.

You might not want to peg compensation directly to this, but rather to relative performance against the alpha (compared to other management strategies), but that's more of a salary negotiation detail.

This is the sort of idea that my brain comes up with when I try to think, except I somehow doubt that I am all that much brighter than the average hedge fund manager. I hope I'm not just wasting your time with the obvious, but why doesn't a system like that work?

I'm not an investment expert, but wouldn't there be virtually unlimited upside in an optimal hindsight strategy? I.e. you could use derivatives and other financial instruments to gain an arbitrary amount of leverage and hence return, since there would be no risk.

Expanding on this, this idea of looking backwards as a method determining what returns you could have made is actually the root of a lot of _bad_ investment advice.

People often look back and try to determine some type of optimal portfolio that they claim is the best in all economic environments because they found it to be the best portfolio in the certain timeframe they looked, but they had the benefit of checking hundreds of different potential sets of funds and if you were to actually calculate the probability that composition of funds is better than any other composition you'd find that it was just random chance it provided the best returns over that time frame.

Granted there is a lot to learn from looking back, but it's also very imperfect if you're not taking in to the benefit of hindsight.

Compensating for this effect of training may be done by properly discounting the measure using the Deflated Sharpe Ratio or similar corrected SR's. I always ask any interviewee who cites experience producing these measures a question with this effect as the crux. Few come back with a correct answer.

These days a lot of the money in Hedge Funds is institutional. Typically institutional investors coming to funds already have a specific allocation to an investment style, market, or asset class that they are trying to fill. So they already have an idea of whether they want market exposure, which would be benchmark oriented and should have high correlation to the benchmark/market, or whether they want no market exposure, which would would have low to zero correlation to the market (they also could want exposure anywhere in between). So in long only (no shorting) funds benchmarks can be arbitrary (though are usually indexes), but they are fixed and agreed upon by manager and investor.

The mandate for the manager in benchmark oriented strategies is to track the agreed upon benchmark with a correlation (or more accurately Beta) of as close to 1 as possible, while still beating it by a certain margin. So if the benchmark is up 10, the fund should be up 15. If the benchmark is down -10 the fund should be down -5. Technically, this margin is often measured not as the difference between the fund and the benchmark but as the annualized standard deviation of the difference, known as the Tracking Error(TE). The TE is typically agreed upon between the fund and investor(s).

It's very common for a fund to charge only a management fee in benchmark oriented strategies. In a benchmark oriented fund with a target TE it would not really make sense to charge performance fee on the magnitude total fund performance since that will largely (or completely) be a function of the benchmark/market - remember correlation should be 1. It also would not make sense to charge performance fee on the excess return over the benchmark because that is incorporated into the TE and should be relatively constant over time (in the example earlier the fund should always beat the benchmark by %5.

So usually there is just the management fee. The reasoning is that if a fund can yield consistently high returns with a consistently low risk (as measured by vol/std. dev. of excess returns a.k.a. TE) then they have some skill and should be compensated accordingly. The excess returns adjusted by risk of excess returns is called Information Ratio (IR). IR is analogous to Sharpe Ratio(SR) in non benchmark oriented funds. In a long/short fund, the higher the SR the higher the fees usually. Similarly, in the long only benchmark oriented fund, the higher the IR the higher the management fee.

This is how fees usually are determined for funds that have benchmarks.

>This is called a "relative return" strategy. Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

I'm not who you're responding to, and I've never heard of "relative return" strategy, but it makes perfect sense to me and your hypothetical poses no confusion in my eyes. If the benchmark (agreed upon in advance of course) would have caused my money to go from M to B by the end of the year, and the hedge fund actually caused my money to go from M to H, then they get paid some percentage of H - B. It's completely irrelevant what M is in relation to H or B.

> Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

Some percentage of 20%, the amount by which the fund outperformed the benchmark. This makes total sense to me, at least. Or rather, it's no more nonsensical than letting the fund manager take a cut of all the assets under management, win or lose, which is a common compensation strategy and has never seemed remotely reasonable.

You obviously need a way of compensating the fund manager during a bear market, or else you're going to have your staff leave as soon as the market starts declining, because they won't be getting paid. So any scheme that doesn't pay the fund manager for losing less money than the dead-hand benchmark is pretty severely flawed.

There is usually a separate fixed percentage of assets fee for just this reason, typically 1%.

There is usually an inverse correlation between Sharpe ratio and capacity. That is, strategies that produce very high risk-adjusted returns stop working if you crank up the size of the book. So the groups running the really high sharpe stuff (HFT latency arb, for example) don't even bother taking outside capital since they wouldn't know what to do with it. This also allows them to keep a higher portion of the profits. On the other hand, groups that are doing lower sharpe but higher capacity strategies (say, Bridgewater) need to raise giant pools of money from outside investors. So really, the most sure bets aren't available to the public.

> So the groups running the really high sharpe stuff (HFT latency arb, for example) don't even bother taking outside capital since they wouldn't know what to do with it. This also allows them to keep a higher portion of the profits.

There are some hedge funds that run prop shop style strategies, but they charge far more than 2/20.

Some strategies aren't about beating a benchmark but providing non-correlated market returns. By that I mean returns which don't go up or down based on the direction of the market.

A good example are catastrophe bonds and weather derivatives. Both are completely uncorrelated with the market, dependent more on weather forecasting, actuarial tables and region specific data.

Because you want your fund manager to outperform the overall market.

If the economy tanks, and everything is down 10%, and you are only down 5%, that's definitely a 'win' for you.

This is not the 'bad part' about hedge fund, there are other schemish things they do.

Considering how hard it is to be 'up' when the entire market is 'down' this doesn't seem so bad. Considering the average hedge fund performances in a down market, it definitely looks like a win to me.

picking a benchmark is actually quite hard

adjusting for net and gross exposures and volatility is makes things more complicated

A fund could simply pick a tradable benchmark like the S&P 500 and short it against its stock picks. Then the investor would pay only on the difference. There's plenty of long-short funds that are essentially flat the market.

Depends on what you're after. You might be touting your ability to guess the market as a whole, in which case absolute return would be a reasonable target. Or you claim to be able to beat the market, in which such a scheme makes sense.

We had one investor who asked and got this kind of model. It creates a ton of complexity (say if the investor takes some money out, you don't count the gains that this money would have earned since that point. Then imagine they put more in later - now you have to track the hypothetical returns on that new money, but not from the original investment but from the add-on time. Trust me the math gets heavy). It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately. Then imagine trying to show net of fees returns for the fund for marketing purposes. Do you show the returns of the guy who invested when the benchmark was low and may not have paid any fees due to relative underperformance? Or the guy who invested at the optimal time and got the biggest outperformance and paid a lot more in fees relative to the first guy? Good luck justifying your choice to an SEC examiner. This is why even the savviest investors don't ask for what you are suggesting.

This does not seem like a serious objection to me. Hedge funds track, keep track of far more complicated financial arrangements. Just valuing options to see when they are in the money is orders of magnitude more complicated. What the op suggests can be done using nothing more complicated than a spreadsheet. "It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately" - huh? Maybe 300 years ago when you had nothing but pen & paper. This is like saying it would be impossible for a mortgage issuer to keep track of each lenders current (adjustable) rate

"It creates a ton of complexity (say if the investor takes some money out, you don't count the gains that this money would have earned since that point. Then imagine they put more in later - now you have to track the hypothetical returns on that new money, but not from the original investment but from the add-on time. Trust me the math gets heavy). It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately"

Computers are good for these kind of things. It isn't as if the hedgefund analyst has to use an abacus to calculate and record the data by hand inscribing stone tablets. I'm sure the existing procedures for other parts of the business (say valuing options) are equally or more complex and computers are handling them just fine.

And if you really can't be bothered to keep track, restrict subscriptions and redemptions to the end of each quarter, and work out performance and fees quarter by quarter.

Its only become clear lately that most managed funds don't out perform index funds.

No matter your trade, if you are smart you want to be paid for your time invested into something and get some upside, regardless of what you are doing for a profession.

Some funds take years to show a return, would you develop software for years and build the business for it without drawing a salary for that work? Most people can't afford to try.

Most folks in finance who can raise this kind of money for a fund can simply make money doing something else, like raising money for established businesses in investment banking. Give the market has shown this model is dead now they will.

> Its only become clear lately that most managed funds don't out perform index funds.

Malkiel's A Random Walk Down Wall Street, in which he explains the Efficient Market Hypothesis and argues that active managers can't consistently outperform the market, was first published in 1973.

So, it might only recently have entered common knowledge, but the evidence has been piling up for a while.

Hedge fund math = regular math. When you charge 2 and 20 but have slim or negative returns, the 2% dominates the 20%. Investors don't like the fixed part of fees, and want to be able to claw back some of the variable fees when later years are bad. Note that this already happens in reverse due to high-water marks (e.g. if you lose 20% one year and then make 25% the next, you don't get a performance fee since you're just back to even). Some investors would like to be able to do the same but in reverse.

In my mind, this is a business like any other. With more competition the price goes down. For HF that means lower fixed fees, higher hurdle rates, lower variable fees, or some combination. On top of that, you can look at it like any risky contract. If you want lower fixed fees, you'll have to pay more in variable fees, and your expected cost will be higher as the managers bear more risk

This is nothing like regular math. It isn't even like its closest competitor: private equity. They only get to take performance fees on exits, which can take years or even decades (or never) to materialize.

Isn't the buying and selling of a stock in a hedge fund analogous to an exit? They happen more frequently that deploying capital, but the only big difference is that in a hedge fund you're expected to reinvest that money. So the math is exactly the same as in a PE fund. If a trade or portfolio company tanks, you won't make your performance fee on it.

PE companies also can charge fixed management fees.

> It isn't even like its closest competitor: private equity. They only get to take performance fees on exits, which can take years or even decades (or never) to materialize.

I would argue that private equity is much worse on fees than hedge funds. Among other offenses, they're able to charge fees to both portfolio companies and investors. The investors usually get a credit for the fees paid by portfolio companies, but it's not a 100% offset.

To an outside observer, this seems to buy you performance that isn't too different from exposure to infrequently marked leveraged standard risk premia.

Private Equity has its own little scams, no doubt. But that doesn't excuse the hedge fund business's "top tick" performance fee scam. Basically, a person like Ackman and some friends could (in theory) bid up a stock 1000%, mark it there at the end of the month or year (or whenever they account for the performance fee), take their performance fee on that mark, and let it crash. In fact, doesn't that sound a lot like Valiant? 30% of the company was owned by Ackman and people close to him.

this would make for a good story line in Billions.

> Basically, a person like Ackman and some friends could (in theory) bid up a stock 1000%, mark it there at the end of the month or year (or whenever they account for the performance fee), take their performance fee on that mark, and let it crash. In fact, doesn't that sound a lot like Valiant?

How much do you think Ackman lost in personal money on Valeant? You don't think it's much more than the performance fees that he earned from it?

Hedge funds and PE firms aren't typically direct competitors. The goals and risk profiles of the funds don't typically align (and hedge funds aren't monolithic as a group, either), but beyond that, there are typically regulations governing which entities can invest in which type of funds. The LPs in big PE funds tend to be large institutional investors--pensions, endowments, and the like. Hedge funds tend to have mostly high-net-worth clients.

> The LPs in big PE funds tend to be large institutional investors--pensions, endowments, and the like. Hedge funds tend to have mostly high-net-worth clients.

The LPs in big hedge funds also tend to be institutional investors.

Venture Capital charges huge fees. The Kauffman Foundation had a study in 2012 [1] of their VC investments over the previous 20 years, and concluded:

* 78% of funds did not return enough to justify investment, given the risks and long lock-up. * The average VC fund fails to return investor capital after fees.

PE as a whole hasn't done much better [2].

It's a dismal industry – for investors, that is, not necessarily for the employees.

[1] “WE HAVE MET THE ENEMY... AND HE IS US”, http://www.kauffman.org/~/media/kauffman_org/research%20repo... [2] NY Times: Pension Funds Still Waiting for Big Payoff From Private Equity, http://www.nytimes.com/2010/04/03/business/03equity.html?pag...

How does clawing back some of the variable fees alleviate the fixed part of the fee? You're still paying the fixed part of the fee no matter what!

It sounds like you work at a hedge fund and are rationalizing...

some historical context...the problem is that the 2 in the 2 and 20 hasn't come down as asset gathering exploded.

When hedge funds first started the pools of capital were much smaller, and the management fee was there to keep the lights on, and provide the cash flow stability to pay top people etc. (essentially cover overhead). As AUM exploded, especially at the largest funds, management fees became a profit center...this has changed a lot of incentives...

The later part of the article claims that the 2-and-20 prices have indeed come down pretty significantly. Supply and demand works.

>Hedge fund math = regular math. When you charge 2 and 20 but have slim or negative returns, the 2% dominates the 20%.

That's not the real problem. That part is intuitive. The real issue is that "20% of profits + 0% of losses" is equivalent to "20% fee, also you give them free money when the stock drops". People tend to focus on the 20% and that leads to highly inaccurate expectations.

Buffet has said this about hedge funds for a long time now. Their fee structure incentivizes volatility, not long term performance, which is a bit ironic because the reason for the name "hedge" fund is that they should have the ability to do better risk management.

Exactly. This is the real problem here, not the fairness of the fee structure. There is vanishingly little "small dollar" money in these funds. The median investor dollar in a hedge fund is a big player, and expected to be sophisticated about these things and to understand how the risks work.

The harm is to the market as a whole, not the poor investors who get hurt in a down market.

How is this a harm to the market? There's nothing inherently bad about volatility.

Yes there is. Volatility is an inefficiency, by definition. Efficient markets seek to the correct market price and stay there. A "volatile" market is one where parasites (c.f. hedge fund maniacs) siphon off capital due to games like this.

> Their fee structure incentivizes volatility, not long term performance

Can you explain why?

Suppose the fund gets 2% of all profits in a profitable year and gets nothing in an unprofitable year.

Scenario 1: 100 million dollar profits for two years in a row. Fund gets 4 million, customer gets 196 million.

Scenario 2: 300 million dollar profit in the first year, 300 million dollar loss in the second year. Fund gets 6 million, customer ends up with -6 million.

On a large scale, what this means is that the fund can look for large ups and downs because they gain every time there's an up, but they don't lose when there's a down.

Now if you parallelize this (so it's happening at the same time with many different customers), it means they can focus on risky bets. Maybe half their customers will win and half will lose, but the fund makes money on the winners and isn't hurt by the losers.

Most of the arguments in this comments sections are outdated. The same goes to the 'Buffet argument'. Most of the funds (after 2008) run with High-Watermark rule. Thus, in the case of your Scenario 2, fund will get nothing from the next 300 million it makes (apart from fixed fees). Thus, the investor will end up with 294 million at period 3. Just like if the fund made 100 million for 3 periods consequently.

That applies if people leave their money in the fund forever. If some of that cycles then there are no high water marks on the new money.

Quite right, though the high water mark approach predates 2008.

The article sums it up pretty well. If the fund goes up and down a lot, the managers make money in the up years but don't lose it in the down years.

The article is wrong. See the other comment about High Water Mark. Long-term the fund only takes the profit on the total return.

The problem with the high water mark is there's then an incentive for managers of deep underwater funds to close them and open new ones.

That's an incentive of any business owner that loses money. It's the duty of investors to review the managers reputation and not give money to known "fraudsters" (unless they can negotiate an incentive structure to prevent such problems).

How so? If you're running a widget factory, you can't just close it and open again with the same machines and staff under a new name. Your investors would have good reason to sue you. And in any case you're not paid a proportion of your shareholder's returns.

With a fund, which is a separate vehicle advised by a management company, the fund can be closed with the knowledge (typically code, and who is gonna know if you take that?) kept and used to run another fund.

And it needn't be terribly blatant. If a guy has a reputation as a stock picker, he can do something like open a new fund for another geography or sector.

Investors can be strangely loyal, too.

> you can't just close it and open again

Actually, you can if you declare bankruptcy.

You just pick up the factory, set it up in a different part of the world, and start it up again?

You don't even have to move it. You can set up a pre-pack insolvency, then buy up the business - assets, employees, stock, everything - in a new company and just keep going, but without the debt. There have been some scandals about business owners doing this, but I don't think it's been entirely effectively stopped.

There are some funds that have much better incentive structures than the standard 2-and-20. In particular, some funds charge an incentive fee over a hurdle rate of say, 6%. Even more fair to investors - this hurdle rate compounds and is subject to a high water mark - where the management company must beat the previous highest amount attained by the fund by the compounding hurdle rate. Additionally, some managers also credit any (usually lower) management fee to the incentive fee.

The downside is that the incentive fees get much more complicated - too complicated to lay out here. I've modeled the scenarios in the following Google Spreadsheet (feel free to copy and play around with this): https://docs.google.com/spreadsheets/d/1RlB4iwg42dEa-atdti4H...

If you do check it out:

Notice that in the [high ret] scenarios, there's little difference in total fees charged between the "fair" 6% hurdle and the 2-and-20 scenario. However, in the [low ret] scenario, the fee difference can be quite substantial: $227k for 2-and-20 vs $70k for the 6% hurdle scenario. And the resulting

Please feel free to copy and play with the values if you'd like. I'd love to discuss in more depth.

The 6% hurdle is a reasonably fair expectation of annualized stock market returns going forward for next 10-20yrs. If there's sufficient interest please reply to this comment and I can detail reasons why, most likely in a full fledged post.

(Over the next 3-5 years, I believe "market returns" - defined as those received from SPY ETF - are likely to be less than 6% from this point (Dec 23 2016), possibly significantly so.)

I'd love to hear why you believe 6% is a reasonably fair expectation of annualised stock market returns going forward for the next 10-20 years!

I'd love to hear his rational as well, in the meantime, here's what I've found:

https://www.elmfunds.com/blog/video-the-most-important-numbe...

It's in line with historical averages, some decades are slightly down or up a lot, but over, say 30 year horizons, public equity delivers reasonably consistent returns. A 6% real return on the S&P 500 is a pretty standard assumption in the finance biz.

http://www.fool.com/investing/general/2016/04/22/how-have-st...

FWIW, I think it's optimistic to assume 6% real returns for retirement planning purposes the coming decades.

Serious question: Why do you think that and how did you get there?

Real returns 1950-2009 are 7% [1], so my numbers are already rounded down a bit. You might further adjust for, say Shiller 10 year P/E numbers, but how complex do you want to make it?

[1] http://www.simplestockinvesting.com/SP500-historical-real-to...

great spreadsheet, one small error:

in the "[high ret] 0.5 / 25%, 6% hurdle" spreadsheet, column R references the "[high ret] 0.5 / 25%, 6% hurdle" spreadsheet (rather than itself)

Glad to see investors are starting to push back on these ridiculous fees. For decades, the whole hedge fund industry, along with more traditional actively managed funds and financial advisors have been charging fees that can't possibly be warranted by the "value" they add.

I don't doubt that there are strategies and traders who can add skill-based alpha to broad market returns, but the catch is that it is essentially impossible to attribute performance to skill or luck. You may say consistently outperforming the market for 5, 10 or even 20 years is the mark of a great investor, but given the number of funds and players in the space, simple statistics would conclude such outcomes should routinely occur. You see it again and again where some manager has a remarkable run, raises tons of money, and proceeds to encounter mediocre/terrible performance. Some former "genius", do-no-wrong managers have actually lost way more client money than they've ever made because they attract tons of money after a lucky run and then proceed to tank.

The silliest part of the hedge fund industry is seeing all these funds and media retro-fit all kinds of rosy superlatives and sophisticated explanations onto a good year or two run, without ever acknowledging the likely role of luck and randomness.

Warren Buffets essay "The Superinvestors of Grahm-and-Doddsville" perfectly captures so much of this dynamic in a fun hypothetical exercise: http://www.tilsonfunds.com/superinvestors.html

To the extent that anyone is able to run a strategy that does beat the market:

a) they probably can't tell the difference between getting lucky and exploiting a niche

b) if they take on more capital their movements will be discovered and the strategy will fall apart

If you're well connected I'm sure you can eventually find a few funds trading on true insider info or novel strategies... but good luck getting in. As soon as the cat is out of the bag the party is over.

For the rest of us: forget it.

https://www.bloomberg.com/view/articles/2015-05-05/rich-hedg...

>But "hedge funds are a compensation scheme masquerading as an asset class," and maybe there's some value in the compensation scheme itself. If you are looking to hedge funds for outsize returns, you might want to pay your manager an option on your returns, by giving him a performance fee of 20 percent of the upside and limited penalties on the downside. Options increase in value with volatility, and giving a manager asymmetric rewards might encourage desirable risk-taking. That might be exactly what you want if you're a pension fund investing a small chunk of your portfolio with hedge funds in order to earn above-market returns. On the other hand, if your manager is already a billionaire investing a big percentage of his net worth alongside you, he might be more conservative with your money than you are, or than you want. It's probably more important for him to stay a billionaire than to rack up more money.

Curious how liquidity works against hedge fund investors.

Contrast a VC fund and hedge fund charging 2 and 20 on a $10 million investment over 5 years. Suppose they invest in identically performing assets. They buy at 100, it's valued at 110 at the end of Year 1, 200 at the end of Year 2, 190 at the end of Year 3, 180 at the end of Year 4 and 170 at the end of Year 5.

Both collect $1 million in management fees (the 2). VC collects 20% of the $7 million profit it made, i.e. $1.4 million. This happens once; VC carry is typically assessed only on distribution. So total fees of $2.4 million or roughly 1/3 of the gains.

Hedge fund managers calculate gains, and thus carry, at the end of each year. Our manager thus collects 20% of the $1 million Year 1 profit and 20% of the $9 million Year 2 profit, i.e. $2 million of Year 1 and Year 2 carry. No carry is earned for the subsequent years. Together with the management fees we have $3 million of fees for the same $7 million of gains, i.e. over 2/5ths of the profits or 25% more than the VC.

What your describing is very unlikely to actually happen. Further, VC's don't deal in highly liquid assets making pre sale numbers basically meaningless.

> What your describing is very unlikely to actually happen

Things going up and then down?

Let's use the S&P 500 [1] from the beginning of 2007 through the end of 2015. Same 2 and 20 on $10 million investments.

9 years means $1.8 million of management fees. Gross gain is 44%. Assuming we reserved for management fees at the beginning, this means $1.8 million in profits over the $10 million (44% on $8.2 million), i.e. $0.36MM of carried interest. $2.16MM of fees with the VC carry-on-distribution model on $1.8MM of gains.

Our hedge fund manager, on the other hand, collects each year. The same 44% catches 3.5% in 2007 gains, 25.8% in 2013 gains and 11.4% in 2014. So $0.14MM of carry in 2013 and $0.24MM in 2014. $2.18MM of fees using the HF year-to-year assessment model on the same asset. That's almost a full percentage more in fees.

Note that this toy model understates the difference since when the manager moves assets to their carry pocket, they no longer compound for the investor.

[1] http://www.1stock1.com/1stock1_141.htm

VC having an accurate price. But, also those price swings in your example where odd. Useually you get steady gains then big drops followed by steady gains across years. Not big gains followed by years of losses. If nothing else inflation is pushing up prices.

+10% +90% -10% -10% -10% is odd. More likely pattern +10% -50% +10% +10% +10%

PS: You can model the s&p 500 for 10 years with each model and compare gains. But, try it every year from 1950 - 2015 not just one year.

This makes complete sense. The Investor is paying extra for more liquidity (they can withdraw from HF probably at least once a year, whereas VC only returns the money after 5 years).

> The Investor [sic] is paying extra for more liquidity

I'd be curious to see if hedge funds with stricter redemption terms calculate profits on distribution only. In my experience, that has not been the case.

Not exactly sure what you're asking but happy to try answer any q's.

Couple points: I realize your example scenario is very hypothetical and just rough math, but a heads up about understating fees as these add up fast: For the hedge fund in year 2 when the value of the fund doubles to $20M or whatever it gets to, the 2% management fees are charged on those higher amounts. So after year 1 fees are ~$400k, ~380K, $360K etc...

With that said, a hedge fund is going to have much higher operating costs than a VC firm. The trading systems and technology costs at hedge funds can get very expensive and it comes out of the 2%. What does a VC firm need 2% every year for? Many of them seem to do their job using only a blue bottle coffee gift card and an iPad to check their schedules and answer emails, what are those management fees spent on?

Also despite having 2 and 20 in common, hedge funds and VC funds are completely different animals, comparing them is really apples to oranges. But yes in your example HF managers can earn more, one could just as easily come up with a scenario where the VC guys earn more.

Lastly, in some cases there is "clawback" on hedge fund fees. The hedge fund would give back some of the previously earned performance fees if say there's consecutive down years. It depends on the terms of fund, every fund is different and the documents of a fund's terms can be hundreds of pages long.

> Not exactly sure what you're asking

Pardon me, that was "curious" as in "exciting attention as strange, novel, or unexpected" [1], not short for "I am curious". That said, thank you for your comment.

> one could just as easily come up with a scenario where the VC guys earn more

When comparing carry-on-distribution versus carry-on-mark, ceteris paribus, I don't think so. High-water marks and clawbacks help, but they're ultimately a patch for a time-horizon mismatch between the LP and the GP.

Note that I wasn't comparing VC and hedge funds. I was comparing how they calculate carried interest. A hedge fund manager charging carry like a VC would assess on redemption, or at least only when a position is sold. The liquidity and transparency that benefit investors also give hedge fund managers another way to charge fees.

[1] https://www.merriam-webster.com/dictionary/curious

Haha, oh that definition of curious. My bad. (side note: I am curious why the M-W dictionary puts the archaic and obsolete definitions first)

Gotcha on the carried interest. Ya we have come a long way from sailing molasses across the ocean to calculate a carry. While scenarios and clauses can change payment to managers, c.p. or not, if we cut to the chase I think it's safe to say yes the incentive carry structures in hedge funds generally favor HF managers getting paid much more compared to VCs. When the top HF managers annual pay news articles come out, these numbers can get crazy, top 10 HF managers can make more in one year than the entire net worth of a top venture capitalist with decades in the industry. But VC guys get to do way more interesting investing, meeting with new tech companies is much cooler than public equity research I think. Thanks for posting this article btw.

> sailing molasses across the ocean to calculate a carry

Got a reference on this? Sounds fascinating.

https://en.wikipedia.org/wiki/Carried_interest#Definition_an...

https://dash.harvard.edu/bitstream/handle/1/12274462/Legnani...

Do we know if the customers definitely pay the fees in full? One might imagine a large customer (like a pension fund) might be able to negotiate a discount, and the discount might not show up in the published returns, or something like that?

http://www.zerohedge.com/news/2016-12-22/traditional-2-20-fe...

It's unusual to pay the sticker price.

Small to mid-size funds may not be able to get away with charging 2-20 but larger, more established funds still can regardless of size. Tudor was charging 4-23 on one of its funds. Not sure if that's still the case since they were down a bunch this past year.

Fees are coming way down in the industry - very few shops can charge 2 and 20 these days. A flat fee of 1% is much more likely. Bill Ackman was a rockstar od the industry, so could get away with it for longer than most. Not any more.

Even in the old days, 2 and 20 was the starting point for a negotiation. If a client can bump up a firm's assets under management significantly, they have a lot of bargaining power.

Usually bigger clients negotiate their own fee structures.

The fact that supposedly "sophisticated investors" didn't figure this out years ago amazes me. Hedge funds, as a class, don't perform that well.

The main difference between hedge funds and regular mutual funds is that regular funds have to report their numbers in a standardized way. The SEC requires mutual funds to report 1, 5, and 10 year performance, after all fees. Hedge funds don't have to do that. That lets them boast about their performance in good years, and shut up in bad years. This fools a surprising number of investors.

Under US law, hedge funds are for "sophisticated investors". Unfortunately, pension funds qualify.

Every one knows this, its not news...

As to the boasting about performance, hedge funds are not allowed to disclose their performance to the general public

Additionally, while some hedge funds might not be very different from a mutual fund, there are huge differences in what you can do in a regulated vs unregulated vehicle

Hedge funds are allowed to disclose their performance. About 7,000 of them do.[1] They just don't have to.

[1] http://corporate.morningstar.com/US/asp/subject.aspx?xmlfile...

and i'm pretty sure you have to attest to being an accredited investor/QP to access it, i.e. its not open to the general public

This is why I tell young people that math matters to them. Not understanding math correlates with managing ones' investments poorly.

It's also sad that nothing in high school teaches students a thing about what a balance sheet or a P&L statement is, or what debits and credits are. They don't teach anything about how business and the marketplace works - things that are very important to managing their adult lives.

>The answer can be found in relatively simple math. As a simple example, consider an investment of $1 million in a fund that generates a 10 percent return in years one and two and then loses 5 percent in years three and four. The investor would end up with about $1.09 million, a total gain of $90,000, or 9 percent, over the four years before fees.

1,000,000x(1.1x1.1x0.95x0.95-1) = 92,025

Why do you bother rounding down the figure and using a different unit (m$) if you are going to use the same unit eventually. ($92,025 = $0.09 million = $90,000).

>the fund manager earns $20,000 and $20,400 for a total of $40,400

And then they proceed to take $400 into account. Vexing.

Ah yeah, was wondering where that $400 came from

Presumably the people who invest in hedge funds are intelligent, knowledgeable people who can understand these fees. The examples in the article don't require more than school-level maths.

So why is there no demand (and ~hence supply) for "fairer" or more-aligned incentives? There must be a price (in management fees) which would eliminate the reward for losing against the market. In which case, is this article complaining about something that is not widely seen as a problem?

"Presumably the people who invest in hedge funds are intelligent, knowledgeable people who can understand these fees." You would be surprised. Many of these investors are large institutional funds like state pensions funds. They have a large sum of money that needs to be put somewhere, preferably with minimum due diligence, and 100s of mediocre indistinguishable funds to chose from. People are more apt to pay attention when they are managing their own money

Do you have citations for this?

For which part?

These investors got off easy as far as Ackman's customers go. Investors in his Target fund (Pershing Square IV) lost more than 90% of their money.

http://seekingalpha.com/article/119879-bill-ackmans-hedge-fu...

for being based in new york, and ostensibly the nation's newspaper of record, the new york times, regularly (either through ignorance or malice, distorts the story

yes - if a hedge fund under-performs, investors still ended up paying a bunch of money for under-performance. I'm not sure what is surprising here.

As it relates to incentive fees, the issue that needs to be discussed is when is incentive calculated, is there a claw back, and is there a high-water mark?

Different funds' positions on these issues varies considerably, but its not some mysterious subject.

How is this not well understood?

The metaphor I always use for people is with lawyers. In most cases (unless they are working on contingency), whether you win or lose the lawyer gets paid.

I'm not that sympathetic to hedge fund investors. Hedge funds are supposed to be high risk - high return investments. If you want a bit more safety put your money in an index fund.

Also, there are some big winners, but I'd be shocked if all the hedge funds together turned a profit after fees.

The hedge fund still needs to be compensated for their time and skillset. In my life, time is the most precious resource I have. This investor's rant has a paradoxical comical impact for a rich man's tragedy.

The fee structure is very simple and transparent. Customers didn't get tricked or legally trapped, they just didn't consider what happens if the fund loses money.

"But where are all the customer's yachts?"

I understand the origin of the phrase, but I always thought I would be somewhat upset if pension funds started buying yachts.

Pension funds are the customers here and it would be pretty bad if they started buying yachts.

You should be, unless they also maintain them themselves -- you know, with those "management" fees.

"But where are the pensioners yachts?"

Institutions who deal with hedge funds (especially public pensions) are loaded with consultants, attorneys, and analysts. If they get hoodwinked, it is probably due to their own lack of due-dilligence.

I think the effort would be better spent covering one of the many cases where ordinary people without consultants, attorneys, and analysts are in a "Heads We Win, Tails You Lose" situation.

For Ackman's underperforming fund to cost you money, you would have to invest in it, and even then, it's still probably not as bad as a lot of "actively" managed mutual funds that charge incredible fees to track similar index funds. That, and the losses are still private.

It's like there's little to no distinction between an iffy private investment vehicle (with private losses) to what the investment banks get up to: Goldman and JP Morgan take risky bets, fail, then have the government/taxpayer top them back up to 100% + profits and bonuses -- while the debtors are still on the hook with little to no government relief.

> Ackman's underperforming fund...[is] still probably not as bad as a lot of "actively" managed mutual funds that charge incredible fees to track similar index funds

Ackman's fund is an actively-managed fund. I think these articles are appropriate for putting guardrails on what public controllers, e.g. of state pension funds, should and should not accept in terms of fees. Nobody is calling for regulating investment vehicle fee structures for wealthy individuals.

This is not realistic in terms of how power works.

When you have a wiz-bang asset allocator like Swensen (Yale) or Bronner (RSA), no one is going to have enough political juice to put restraints on them, and even if they did, typical legislators/administrators are largely too ignorant of the process and fee structures to come up with restraints in the first place.

> legislators/administrators are largely too ignorant of the process and fee structures

You're criticizing an article for bringing attention to something you claim cannot be changed because nobody pays attention to it?

I'm criticizing it for being a non-issue compared to investment banking regulatory capture.

No one is forced to put money in his hedge fund. If his fees are too high and his performance is too low, that's his investors' problem.

Whereas with much of the banking industry, taxpayers are on the hook with little to no say in the matter.

> No one is forced to put money in his hedge fund.

...except the people represented by those "legislators and regulators" that you sneer at for being ignorant, and thus can be educated by articles like this.

Your posts in this thread feel like libertarian position-staking more than anything coherent.

Haven't met many libertarians who complain about regulatory capture.

My complaint is that this article is a distraction.

People who deal with hedge funds (especially public pensions) are loaded with consultants, attorneys, and analysts. If they get hoodwinked, it is probably due to their own lack of due-dilligence.

I think the effort would be better spent covering one of the many cases where ordinary people without consultants, attorneys, and analysts are in a "Heads We Win, Tails You Lose" situation.

That's fair; I withdraw the libertarian comparison and I apologize. But what's to say we can't pay attention to both at once? I feel like this is kind of a false economy.

Any article crying boo-hoo for hedge fund investors is up to something. People who can invest in hedge funds are big boys who can look out for themselves.

At the same time, there are so many bogus mainstream investment vehicles (like so many heavy-load, low-performance mutual funds that a lot of employees are stuck with because that's what their 401k offers), advertised in newspapers and television, that are far more deserving of media scrutiny. I can't help but suspect that part of the reason why they are not scrutinized is that they are well-paying advertisers.

Ackermann is probably getting a colonoscopy here because he is not an advertiser.

Yale is a private institution, i am not familiar with RSA. I personally would like to reatrict all gov pension investments to passive, low fee only.

The impact on actual dollars would average nationally to be positive. The impact on accountability would be absolutely amazing. The accountability would happen because everyone (all gov pensions) would have to assume similar future returns.

There's always fun stuff like this: http://dealbreaker.com/2016/12/cocaine-prostitutes-perks-new...

"other than the obvious don’t-defraud-public-pensions one – is that if you’re going to accept recreational drugs and sex services from state contractors, be sure to properly disclose it all to the relevant authorities." Good words to live by.

Provided an entertaining read on my morning commute on the MTA.

"Give me control of a nation's money supply, and I care not who makes its laws." --Rothschild, 1744

Reply on news.ycombinator.com