Proving once again that the quickest way to make mortal enemies in the hedge fund or private equity world is to question the sacred two and twenty cow, I received dozens of emails commenting on my view yesterday, one that is, I might add, shared by The Economist, that hedge fund clients might be "paying alpha prices for beta returns." You would have thought I had been at a "ban the bomb" rally in the 50s for all the popularity of my position. I'm still waiting for the subpoena from the House Committee on Un-American Activities and I think the FBI has been following me ever since yesterday afternoon.
I suppose I should also make the observation that most of the emails came from hosts with the word "Capital" "Advisors" or "& Co." in them. I leave interpretations of these facts with respect to the demographic of the email senders to the reader's gentle predispositions. In deference to those gentle predispositions I will also refrain from quoting the profanity in two of the emails.
Nearly 66% of the responses indicated that hedge fund compensation at two and twenty is justified just as it is because hedge funds are performing a service by developing portfolios uncorrelated to the market. This, many voices argued, justifies the two and twenty structure. Others commented that hedge funds provide "absolute performance" rather than relative performance. This, they insisted, justifies two and twenty.
Said one reader/writer:
..suppose I promise my investors that I will deliver 14-15% returns, net fees, every year without reference to the market at all. This causes them to invest. Since I'm an investing genius, I deliver on my promise.
Reader #2 could well be finishing Reader #1's sentences with:
Why on earth would I want to tie my compensation to what the S&P does in a given year--a variable that I have no control over, and that has nothing to do with either my value proposition to my investors or the success or failure of my investments?
Reader #3 chimes in as if this were a AA meeting:
A hedge fund is suppose to construct its portfolio to eliminate/minimize market impact (beta) hence "looking for Alpha" so its theoretical benchmark should be zero, rather than any sector/market index.
This uniformity strikes me, frankly, as well conditioned responses from Kool-Aid drinkers in the industry.
"Why on earth would I want to tie my compensation to what the S&P does in a given year?" Oh, I am sure a hedge fund manager wouldn't, but I am equally sure that the hedge fund manager would love to just be handed $100,000,000 at the end of the year, regardless of performance.
What is at issue here is a disconnect, I believe, in the value proposition. Hedge fund clients are not, I suppose, particularly impressed with the quantitative elegance of a manager's portfolio. For the most part, and aside from wanting to preserve diversity, they are interested in returns. They are, after all, in business to make money, not to fund creative correlation discovery projects that under perform the market. We are dealing with pension funds, not with theorists that derive utility from investing in some sort of aesthetic beauty in portfolio design.
If we agree that investors are in it for returns, and we also agree that cheap returns can be had for pennies via index funds during bull markets, then what justifies charging hundreds for the same returns in that environment?
"Clients aren't paying for returns, they are paying for uncorrelated returns," quipped one reader. "They are paying for the downside protection." Well, if that's so then why would they willingly chip in fees during a bull market when that downside protection is purely theoretical, and might not exist at all? Is it an option on downside protection? If so, it is an awfully expensive one when it also charges for the market portion of upside. And then, there's the problem of enforcement. How do you know if you are paying for alpha when your investment returns 11% on the market's 10%? The answer is you do not. Accordingly, it seems silly to permit compensation schemes to ignore the potential gap here.
And what of this reader: "..suppose I promise my investors that I will deliver 14-15% returns, net fees, every year without reference to the market at all." I think that the manager that makes this promise will be leveraged 8:1 long on natural gas bets. So much for downside protection. Personally, I think The Big Picture covered this issue quite effectively back when it reared its ugly head last.
If we are serious about paying for uncorrelated returns, then our fee structure should be based on demonstrably uncorrelated returns. I'm open to suggestions but the only real obvious answer to me on this is the one I've already presented. Index linking. This is, clearly, presently unpopular, but I suspect that clients will wise up quickly. Then again, maybe not. Two and twenty has a lot of intertia. It might take a sharp downturn that results in some unexpected losses (and some revealed beta) to shake things out. Even then, who knows?
(Photo: The House Committee on Un-American Activities prepares to apply the thumbscrews).