Then what's the value in a fund manager instead of a simple algorithm that follows the market? Would you hire an employee and pay them the entirety of the value they generate for your business?
What a preposterous argument.
By Matt Levine
Here is a simple model for hedge fund fees:
1. There are some people who can reliably generate alpha -- returns in excess of the market return -- but those people are rare.
2. It is somewhat difficult to tell who those people are; in particular, at any given time, there are more people who look like they can generate alpha than who actually can.
3. If you are one of the people who can generate alpha, you should charge a fee for your services that is equal to the alpha that you generate.
4. If you are not one of those people, you should charge a fee equal to the alpha that those people generate, because then investors might think that you're one of them. "
So, best case scenario I get market returns? Then why not just invest in an index fund?
Yes. Note: This is a surprisingly accurate description of reality. Aggregate hedge fund returns are goddamn terrible.
> Then why not just invest in an index fund?
Well, you should, if you're trying to maximise your expected outcome. Of course, not everyone is trying to do that.
In particular, what if you run a pension fund which is currently underfunded, but for political reasons is claiming to be adequately funded through the expedient of assuming that future returns will exceed any reasonable expectation of market returns?
If you invest in an index fund you'll get market returns; since that's not enough this means you will miss your targets, and be unable to pay promised pensions, at which point you'll be fired. But if you give all the funds cash to a hedge fund, or engage in some crazy snowball derivative[1], then you'll probably do even worse than an index fund, be able to pay an even lower percentage of the promised pensions, and you'll be fired. Which is actually no worse for you. But you MIGHT do really well, and actually be able to pay the promised pensions. Not likely, but if it works you avoid you getting fired, and if it doesn't you were going to be fired anyhow, so why not give it a shot?
All of why is completely hypothetical. The fact that many US pensions funds are horribly underfunded using any plausible actuarial projects and are simultaneously investing heavily in exotic asset classes is just a funny coincidence.
[1]: http://www.bloombergview.com/articles/2014-05-02/portuguese-...
If the ability exists at all, it's certainly very rare. And if you are one of the people who has it, why would you hire that ability out to other people? The guy who owns the golden goose is going to sell the eggs, not rent the goose out. Or if he did rent the goose, it would be for an amount no lower than the expected value of the eggs because otherwise he's losing money.
But given these dynamics, that means that there's no reason to think that if you see some guy offering to rent a golden goose it would be a great deal for you. I mean, he's actively trying to price it so it's not, and it's his goose, so he's probably right.
B) Change the point of view from the retail investor to the pension fund, funds have a very narrow and constrained mandate, they need to hedge risks and deal with the increasing negative cash-flows. They can't merely park their money somewhere and hope for the best.
This is what most level headed people who study the stock market suggest you do!
If you are a customer for hedge funds, you should be willing to pay anything up to the expected future alpha based on past correlations between previous and future alpha.
That correlation is always affected by regression to the mean. Therefore someone with a good track record will not be able to charge on the expectation of future performance matching past performance. But only on the expectation of future performance being somewhat better than the market mean.
The ideal if everyone does everything perfectly is that, on average, fund managers that can generate excess alpha will, again on average, capture their entire outperformance as fees.
The market generally has been growing for a long time, with 2008 being a notable exception. If you've been growing money at market pace, then historically you've been doing pretty well.
So from this perspective, it'd make sense to go with the human fund manager who was beating the market and charging exactly his outperformance.
Indeed.
How much more than that does one deserve for mirroring the market returns?