Saturday, October 13, 2007

Hedge Funds and Jim Gaffigan

I was watching Jim Gaffigan (the comedian) on Conan O’Brien the other night and he was talking about the “innovation” of the upside-down ketchup bottle. He said that for years we basically were always holding it upside down and then after fifty years someone figured out, hey, let’s just have it come out the bottom in the first place. He said that future generations wouldn’t look on us favorably because it took us so long to grasp something so obvious…

A pretty funny joke but in fact this is sadly applicable to hedge funds, of all things. Let me explain the connection.

Hedge funds are in the news lately. Two funds run by the major wall street firm Bear Stearns recently went bankrupt and essentially wiped out their investors. This was unexpected because the “hedge” in “hedge fund” implies that the assets were HEDGED in some manner, which means if the markets move in an adverse manner, the fund would be protected through the use of some sort of financial instrument or agreement. Investors might suffer a loss of some sort (say, 10%) but not lose a significant portion of their investment.

While hedge funds are of many different types, they generally share some basic characteristics (wikipedia has a decent summary):

  • Hedge funds are usually limited to high net worth investors (“Accredited Investors) who are assumed to be sophisticated; the average investor cannot directly invest in a hedge fund
  • Hedge funds usually charge an annual management fee as a percentage of assets – say 2% of assets under management each year (thus if they have $1B in assets the fund earns $20M off the top before any profits or other fees charged to the companies in the funds)
  • Hedge funds usually keep a percentage of the profits earned called performance fees; say 20% of profits earned. Thus if the fund earns $200M for investors the managers would keep $40M for themselves. Often the profits have a “clawback” feature where the managers have to give back profits earned in a prior year if the fund has losses in a future year. Alternatively, the fund has to earn a net positive return; if there were losses in prior years, the fund has to earn back those losses before the managers start to receive a performance fee
  • Hedge funds aren’t limited in what they can invest in like mutual funds, and often they aren’t hedged at all
  • Due to the performance fees and management fees hedge fund managers can earn amazing amounts of money – Eddie Lampert (head of the new merged Sears / K Mart) earned over $1B in 2004 and $1B in 2006
  • Many hedge funds have policies that “lock up” investments so that they don’t have to keep cash on hand for distribution; often investors need to keep their funds in for 3-5 years or can only withdraw a portion of their money at a time

While hedge funds sound complicated and exotic, the real key behind the mutual fund is LEVERAGE. For example, in the collapsed Bear Stearns funds, they were leveraged more than 10-1. By leverage I mean using $100M in capital to “buy” $1B in securities; at this level of leverage a $100M gain is 10% on the amount of securities bought but it would be a 100% gain on the original investment; on the flip side, if the securities declined in value from $1B to $900M the original investment would be entirely wiped out.

I have seen studies that say that if you leveraged up the S&P 500 with 50% leverage you’d beat the long term track record of the vast majority of the hedge funds out there; this is essentially how they earn a higher return.

And what about the risk? Well since the managers earn a percentage of the earnings, they have the upside of the risk but they don’t share in the downside. This is a variant of the famous “heads I win, tails you lose” joke.

If the fund starts losing money, the managers don’t hang on and try to earn their money back – what is the point of that? If the fund loses 20% in one year (not hard to do if you leverage money in a volatile market and it goes against you) then the next year they’d have to make up the cumulative losses of 20% BEFORE they earned a cent of performance fees. The fund may exist but the managers will likely bolt; or the fund may get folded into some other entity.

While hedge funds sound exotic and futuristic, they are essentially a leveraged bet on markets. And for this leverage you are paying a very high price; you are paying a management fee of 2% a year and giving up 20% (or more; some are as high as 50%) of your profits. And if the markets go into a swoon or are flat for a while, expect the best managers to bail out and move on because it is easier to start “from scratch” than to make up past losses before they can start earning a new performance fee.

It isn’t fair to brush all the hedge funds the same way; some indeed are true hedges (they have upside and limit risk on the way down) and have delivered big returns to investors even after taking their vast profits off the table. But it is safe to say that the biggest tool in their toolbox is leverage and much of their profits could be had in a much simpler manner without paying a dog’s breakfast of fees and tying up your money for years in an opaque wrapper.

Future generations will look at us the same was as Gaffigan summarizes the upside down ketchup bottle – we were pretty slow on the uptake to figure out that most hedge funds were a pretty expensive and cumbersome way to earn the market return plus leverage.

Cross Posted at Chicago Boyz

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