Wednesday, February 18th, 2009
draw your return

This continuing series on the incentives that model behavior in the investment marketsthe research puzzle | The second installment, “actively unconnected,” was primarily about the disconnects between how a typical long-only portfolio manager is compensated and what the best interests of the fund’s owners might be. now visits a familiar topic:  The fee structures of hedge funds.

I took a crack at this once before,the research puzzle | I called it “the hedge fund dilemma.” when I urged greater experimentation in hedge fund fee structures in the hope of finding some that better match the needs of investors than the industry standard ones do.  There’s no reason to revise the conclusions:  Nothing I have seen since that piece was written in September dissuades me from my belief that the incentives in the hedge fund world require tinkering.

We all know that the raw math is staggering for the hedge fund manager who can raise a bit of money and post some nice returns.  Thus, talent has flowed into the “industry” from other more stagnant pools, accomplishing one purpose of the incentives with ease.  I don’t get hung up on the fees themselves and encourage those that I advise not to either.  The net after-tax return is key; is it reasonable given the risks undertaken and the index returns that are easily (and cheaply) available elsewhere?  A look at the absolute fees on a comparative basis is instructive, however, and there’s no magic in twenty percent.  In a tougher environment, there will be good managers who will create attractive businesses while charging less.

It is not just a matter of the size of the fees, though.  It is time to seek out new approaches and to remedy the excesses and shortcomings of the existing incentives.  Contemplating and addressing gates, walkaways, side pockets, etc. in a structured way will be easier now that the animal spirits are (at least temporarily) in the barn and the supply/demand dynamic for funds has shifted.

Investors in hedge funds should demand incentives that fit the investment goals and processes of a given manager, as well as the pattern of returns that they seek to receive.  The incentives should work for both parties in a variety of environments, with a sharing of pain as well as gain, not for short periods like a year, but for multi-year time periods that reflect the interests of all concerned.

One way of thinking tackling the issues uses a graphical approach from the last posting:

While we could expect that a market-neutral manager and his clients would draw similar patterns of expected (net) returns upon this blank slate, I’m fairly certain that managers and clients involved in other strategies would have trouble agreeing with one another on where the lines might go.  Having an understanding of those expectations is critically important in order to craft the right incentives, yet often they are left unspoken and misunderstood.  Consequently, a simple yet inappropriate fee structure is applied, and it’s no surprise that mismatches occur.

For a given fund, how does the expected return line relate to that of a relevant index?  Is it linear?  What is its beta?  How is leverage used?  If there is optionality, how does it arise?  Where does downside protection kick in?  How is the upside traded away for it?  What happens to the graph as the time period is adjusted?  If it changes, how and why?

These may seem like idle musings — and the prospect of sitting around a conference table comparing drawings quite unimaginable — but it’s interesting how you quickly can understand the differences in expectations that exist through this exercise.  Sophisticated buyers of alternative investments should be forcing transparency in a variety of different ways (and not playing if they don’t get it).  Buying past performance, star managers, and fee structures that are detached from desired outcomes are the province of average investors; hedge fund buyers need to demand a greater understanding than they’ve been allowed to attain in the past.

Thankfully, not too much is needed in terms of regulatory action, although we shouldn’t be lulled into a false sense of security about systemic risk at funds just because the really bad actors were elsewhere during this particular crisis.  Speaking of which, it’s on to the investment banks from here.