Remember hedge funds, those highly secret, private financial companies that operate as partnerships, draw very little regulatory supervision, raise lots of cash from very wealthy investors, and use the cash to trade in and out of various securities, making huge profits for their investors and doubly huge profits for their managers? The managers typically receive a fee equal to at least two percent of the assets they manage, plus at least a twenty percent interest in the profits the fund generates (the so-called "carried interest"). The managers huge compensation amounts (one earned more than a billion in one year) has Congress's attention, because the managers pay very little tax on those huge payouts. They tend to pay capital gains rates (15%) rather than ordinary compensation rates (maximum of 35%). For a review of the issues and the rationales, see some of ataxingmatter's prior postings on partnership carried interets and hedge fund managers' compensation taxation: Partnership Carried Interests: the discussion continues, Fund Managers' Lifestyles: maybe only death is inevitable?, and Private Equity Funds.
As Congress quibbles and delays whether or what to do about the compensation inequities involved, it is worth considering just how important those high compensation managers are to the funds they manage. We know the managers make substantial returns--doing well when the fund prospers because of the carried interest, and doing satisfactorily even when the fund fails, because of the flat fee. The hedge funds seek significant returns better than standard market indices (called an "alpha" return). Do they get them? There's very little information to go on, since the hedge funds are private and do not have to file reports and are very secretive, requiring their analysts to sign confidentiality agreements barring any disclosure to the public about the funds' methods.
There's a great article worth summarizing here: John Cassidy, Hedge Clipping, The New Yorker, July 2, 2007, at 28. Cassidy reports on the activities of Harry Kat, a Dutch economist who ultimately headed the equity derivatives desk at Bank of America before moving to academe, where he is currently at the City University of London. Kat did some analysis of hedge funds and was shocked at the compensation paid to managers. "Who wants to pay that kind of money:...You can't seriously expect there to be anything interesting left after somebody takes out three and thirty." Id. at 29 (referring to the total compensation to managers in "fund of funds" structures where a "master" partnership invests in a number of hedge fund partnerships and extracts additional fees of at least "one and ten" (a one percent fee and ten percent profit commission)).
Since trading strategies of hedge funds are not publicly available, kat studied the information about earnings that is provided voluntarily by the funds to several financial publishing companies. Since hedge funds are risky endeavors (using leverage to increase returns, shorting stocks, speculating on commodities), the return that is reported may not provide full information. Kat therefore compared fee-adjusted returns for 1990 through 2000 for 77 hedge funds to a market benchmark with a similar risk profile and found that more than 90 percent failed to outperform the benchmark. Id. at 29-30. In a second study, he concluded that only 18 percent outperformed their bencharmark. In 80 percent of the case, the after-fee return for the hedge funds was negative. "They are charging more than they are adding." Id. at 30. Other studies show that market movements account for much of the variation in returns, not smart picks by superman managers.
Kat then sketched out a software program to mimic returns of hedge funds by trading futures, trying to accomplish in a very mechanical way what the hedge funds were doing in terms of diversifying risk. Kat says he has succeeded in creating virtual hedge funds that mimic existing ones: "It is possible to design mechanical futures-trading strategies which generate returns with the same, and often better, risk-return properties as hedge funds. ... This means investors can have hedge-fund returns but without the massive fees and all the other drawbacks that come with the real thing." Id. at 31. The program is now available for investors to use, at a fee that is less than a fifth what hedge funds charge.
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