Risk Free Fees

The continuing saga of hedge fund compensation lingers on.  Reader mail continues to spill in on this topic including a recent set of missives that highlight the poison in the Kool-Aid the hedge fund crowd has been drinking.  Count on Going Private readers to ferret out such details (though this one probably should have been obvious) and wield them with cunning and elan.  Says one reader, a UBS alum:

If they are obsessed with non-correlating returns, or at least if they are so concerned with justifying their fees with such promises, then they should be happy to reduce their performance by the returns of a portfolio with beta of zero.

Reader 3 doesn't seem as smart as he thinks he is: a zero beta should return the risk free rate regardless of the index chosen. Such a portfolio should also have very low volatility, otherwise the risk/reward ratio would be very skewed.

This suggests that at a minimum gains for the purposes of calculating fees on a fund that has "uncorrelated returns" as its primary investment goal should be indexed against the risk-free rate.  Perhaps ten year treasuries or some such.  Clearly, other funds which espouse other investment purposes (outsized returns relative to the S&P 500, absolute returns, returns uncorrelated to tin futures) should probably be indexing other indexes.

In the end the only issue is investor education and fee elasticity.  There won't be any pressure downward on fees unless investors vote with their feet.  Don't worry, Polonius fans, given the lack of investor outrage at present, hedge funds don't appear to have much to worry about.