The Wall Street Journal has an excellent letter from Michael Steinhardt (subscription required) on hedge funds. It begins with the wonderfully encompassing phrase, "When I started out 40 years ago, a hedge fund wasn't an asset class; it was a fee structure..." Indeed. It continues:
Currently, thousands of funds manage $1.5 trillion in assets. But this may have more to do with the incentives to managers than the incentives for investors. Performance money management is the highest paid industry in the world. Yet you don't need a license, a degree or even experience to start a hedge fund. Average fees have risen to nearly 1.5% of assets, which means managers don't merely cover overhead, they make a profit -- before they earn their clients a dime.
Realistically, there are a limited number of truly superior fund managers. Yet legions of managers earn extraordinary compensation for what, as the indices reveal, has been ordinary performance. The numbers tell the story. Last year, hedge funds reportedly earned a record $16 billion in fees tied to assets under management alone -- even as average returns fell to almost half the average of a decade ago.
This is a different business than the one I knew. The goal of capital preservation has entered the hedge fund marketing lexicon, where it doesn't quite belong. Performance should not be measured "relatively" but in absolute terms. The goal should be beating the market -- any market -- and having positive returns. It's not about attracting assets, or boasting to clients that you only lost 5% of their money when the S&P 500 was down 15%. As a hedge fund manager, I felt an obligation to investors to consistently -- and meaningfully -- outperform. This was the only way I felt justified in collecting extraordinary compensation. In the 29 years I was in the business, the S&P 500 posted an annualized return of approximately 11%; my firm posted after-fee annualized returns of 24.5%.
Today, performance is hardly spectacular. Since the stock market bottomed in 2002, hedge funds, as measured by the Credit Suisse/Tremont Hedge Fund Index, underperformed the S&P 500 two out of three years. From 1993 to 2005, the CS/Tremont Index virtually matched the 10.5% total return generated by the S&P 500 Index.
Eventually, investors will refuse to pay high fees for average performance especially when so many better alternatives exist, including "passive investing" strategies. The growing gulf between compensation and performance is an aberration that I don't see lasting -- even if so many have so much invested in seeing that it does.