I read a bunch of hedge fund newsletters and blogs (favorite: fintag) and the news is all doom and gloom. This is an industry that is being decimated. Most hedge funds were fee structure scams masquerading as asset classes, as one commentator puts it, and are suffering greatly. I run my own assets like a mini-hedge fund, zero leverage, options gazillion, screw your fees.
As an investor I have several problems with hedge funds.
1/ On average they are average.
I am with Taleb, true alpha is hard to come by. Witness Falcone, he made a killing betting against subprime in 2007, only to score a relatively poor -30% in 08 (hey I beat the pants out of him by being mostly neutral). Because they are unregulated they can invest in all kinds of stuff they don't understand. Being a hedgie is akin to working on a electric saw with no protection. Careful with those fingers!
2/ Too much leverage.
The dirty little secret of the industry was explained to me by a starry eyed hedgie frenchman during my JBoss days, in retrospect I find it quite mundane and dated. "You have $1, you borrow $10. You pay 5% on 10 or 50c you make 10% on 11 or $1.10, net you have made 60c. Your capital is 1 your return is .6 your RETURN ON CAPITAL is 60%. In short you multiply your positive returns by taking on leverage." I immediately said "but if you go down you lose your capital more quickly". Indeed if the multiplier is 6 as above then a downturn of 15% will wipe out 90% of capital. CAREFUL!!! Leverage is cheating in a way, or rather it is good until it is bad and then it is really bad ... for you.
3/ Fee Structure is bullshit.
2/20 is the advertised fee structure, which for the non-initiated read "2% annual management fee and 20% annual performance fee". The big big problem is the ANNUAL part. Why? because a manager has all the incentive to front load risk, leverage like a pig, make money ON THE FLOW until the risk catches up with you and YOU blow up, not him. BTW watermarks are the ultimate bullshit as you close and re-open. When the capital evaporates, the manager goes on holliday, he has already made the money. View it casino style: the manager bets 28 to 31 on the roulette, you do that by covering 28 numbers out of 31. You will win a little every time and the manager takes 20% of your winnings every time. Eventually you will hit a bad number, lose all your money, but the manager has made his tax. In essence, the manager's short term incentive is against your long-term interest as a investor due to the fee structure. He is the casino collecting a tax, you are the chump.
4/ They are subject to runs
Roubini reigns supreme, the shadow banking run beast is now 4 mo old and is only gathering pace. Hedgies are the little piggies in straw houses. Sad story in Fintag this morning: a hedge fund manager that did 40% return last year (meaning 8% x 5 leverage ;) has left his redemption open and investors are running to cash in, he is closing down the fund. They need to liquidate in a panic driving their returns and markets down. Most hedgies put up barriers to redemption. They are also subject to runs from the other side, by the banks calling their loans back or not rolling them. This is what happened last year and what triggered the August 07 panic: there was a lot of forced liquidation going on. Both investors and lenders can run on a fund. Oh and if you are the last one standing you get stuck with the bill to close it down... so run baby run, run, run!
The situation is fundamentally broken if you ask me. I stayed clear of this structure and I am glad I did. Here is a modest proposal.
PROPOSAL: GET PAID ONLY AT EXIT.
Forget annual participation, watermarks and all that bullshit, you are going to align your risk with mine, you get paid when I get paid. Of course you have to collect a management fee in order to put food on the table but I want it <100bips.
You can either leave the door open for fluid redemptions or structure a limited partnership (LP) like the VCs do with a clear lock up and exit time frame. Liquidation can be defined by LP liquidation. This has the advantage of making clear what the lock-up period is, say 5 years. Everyone gets paid on the same monies by the same metric.
In its current for, the hedge fund industry is a vast scam and it has run long enough. It is in its DNA to evolve and evolve rapidly. I am sure the smart ones will survive.