Hedge Funds – a Mug’s Game (but not for the Managers)

22 June, 2009

Why do I think that investors in hedge funds should think twice?  Well, one of the key issues is that hedge fund managers typically take a large profit share (say 20%) in the good years, but don’t take a share of the lossses that arise in other years.  So they tend to like big swings in annual returns.  The effects of this lack of symmetry on investor return can be remarkable over the long run (just as the lack of symmetry in bonus systems for bank executives has had a predictably disastrous effect on the wealth of bank shareholders in recent years).  

By way of illustration of the sweet deal that hedge fund managers arrange for themselves, in the FT “Money” section on 20th June 2009, one of my favourite economic writers, John Kay, has this nugget:       “[Warren] Buffett, the most successful investor in history…. had a fortune of $62 billion in 2008.  In my book, The Long and the Short of It*, I calculated that if he had paid the standard charges of a modern hedge fund for the investment of his money more than 90 per cent of his fortune would have ended up in his manager’s pockets”

In an earlier article in March of 2008, John Kay had written at greater length on his startling finding. 

“During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world.

“The calculation illustrates a more subtle point. Mr Buffett’s fortune has come not through growing an investment management business, but from his own share in the value of the funds he manages. Suppose he had adopted a more conventional investment management structure, charging the 2 per cent management fee and 20 per cent of performance common in private equity and hedge funds. How much of that $62bn wealth would have been the property of Buffett the manager – Buffett Investment Management – and Buffett the investor – the Buffett Foundation?

“The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent……

“You might argue that the seemingly disproportionate share of Buffett Investment Management is reasonable: after all, Buffett Investment Management is very good. So rework the sum on the assumption that Mr Buffett was mediocre and performed in line with the 10 per cent return on the S&P. That would have reduced his wealth to $930m, below cut-off for the Forbes rich list. But only $170m of that more modest sum belongs to investors: Buffett Investment Management would still have the lions’ share, at $760m.

“Worse still, suppose Mr Buffett had been no good at all. If returns had averaged 5 per cent a year, then the Buffett Foundation would have a miserly $32m to pass to Bill Gates’ charities. However, inept but thrifty Buffett Investment Management would still have accumulated $82m.

“The results of these calculations are as puzzling as they are remarkable. But the difference between compounding before fees and compounding after fees builds up dramatically over a long period.”

*http://www.amazon.co.uk/Long-Short-Investment-Normally-Intelligent/dp/0954809327

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