Did Hedge Funds Steal Half Their Investors’ Money?

A report released by LCH Research got widespread coverage with the Wall Street Journal making its headline, “Hedge-Fund Fees Eat Up Half of Clients’ Profits,” and Bloomberg chimed in with, “Hedge Funds Kept $1.8 Trillion as Fees, or Half Their Gains.” The coverage used words like “staggering” and “exploitation,” but I think this is an innumerate reaction.

Before getting to the right way to think about these numbers, I want to address the idea of forming estimates to the nearest hundred million dollars of the total return and total fees of all hedge funds since Alfred Winslow Jones invented them in 1949. It’s difficult even to define all hedge funds, and few of them disclose results to the public. The disclosures some make to databases are not complete enough to make accurate calculations. But LCH has access to a lot of non-public information and a solid reputation for accurate research. I don’t think they know the numbers to the nearest hundred million dollars, but there’s no reason to think their numbers are wildly wrong. Moreover the ratio of fees to investor returns is easier to estimate than the absolute dollar totals of either one.

Let’s start with the numbers for 20 large hedge funds, which I think are more reliable than the totals for all hedge funds. Here we have a defined universe of funds, all very well known, and few enough that each can be examined in detail. According to LCH these 20 funds have generated $1,301.1 billion in total gains since inception, and taken $446.6 billion of that, 34.3%, in fees.

If you think about it, this is not meaningful information. What matters is whether the net investor returns beat the market. If the money invested in the 20 hedge funds had instead been in index funds, the fees would likely have been around $15 billion, one-thirtieth of what the hedge funds charged. But the index funds would not have beaten the market for their investors, only matched it before fees were subtracted. Traditional asset managers might have charged $100 billion, then lost to index funds on average.

Unfortunately, the 20 hedge funds represent a wide range of strategies with different benchmarks and fee structures, so we have no way of estimating the amount of excess return or alpha they delivered to investors. But we can still make sense of the numbers by assuming they were from a single fund that charged a 2% management fee and 20% of profits beyond a 3% hurdle rate (3% is about the weighted average one-month treasury bill rate over the period of operation). This is a reasonable guess for either a low-risk or market-neutral hedge fund.

In that case, the hedge funds’ gross return of $1,301.1 billion represented about 13% per year, and delivered $994.1 billion above the hurdle rate. The hypothetical fund took a performance fee of $241.9 billion, or 24% of the profit above hurdle. 24% is higher than the stated 20% performance fee because investors do not all redeem at high-water mark—both because investors cannot time peaks perfectly and also because they tend to redeem after losses.

But what if we treat this like a high-risk hedge fund run to a Beta of 0.5 to the S&P500. Based on weighted average stock returns over the period, that would suggest a hurdle rate of 6% rather than 3%. In turn, that would reduce the hypothetical excess return to $687.0 billion, and the performance fee would represent 35% of excess profits.

Since the actual funds are mix of high and low risk funds, with different correlations to major financial markets and different fee arrangements, all we can say is it seems these 20 hedge funds are taking something like 30% of excess profits as performance fees.

But this is a biased number because none of the 20 successful funds blew up, and in fact they all posted above-average returns which is why they grew to be successful. If we perform the same calculations for the remaining hedge funds we find they seem to have averaged about a 6% annual return, and taken between 44% and 100% of excess returns as performance fees, say 75% as a ballpark guess for the average.

I understand these are highly oversimplified calculations. If we had fund-by-fund and investor-by-investor numbers we might have very different values. I only maintain that if we’re guessing from the numbers we do have, a 30% effective performance fee for top hedge funds and 75% for other hedge funds are not unreasonable.

Now comes the question of what effective performance fees should be. If a manager has unique and certain alpha, then she is in a position to charge any amount that leaves investors better off than not taking the deal. Even with a 99.9% performance fee, it would make sense for someone to invest.

However, there is a behavioral economics literature called “ultimatum games” that suggest empirically investors would reject wildly unbalanced splits, even though turning them down results in lower overall returns. The literature suggests even the unique and certain alpha manager could not take more than, say, 75% of excess performance to gain traction with investors.

Of course, no real manager has unique and certain alpha. At the other extreme is a “hedge fund Beta” manager who offers well-known, inexpensive-to-run strategies that beat index funds over the medium-term, but which are essentially identical to competitors’ funds. These funds do not have certain outperformance, they have periods of doing better and worse than the benchmark. Economics argues that fees for these funds should be competed down to cost. Since cost is unrelated to performance, this means a zero performance fee, and a management fee only large enough to cover expenses—including the manager’s time and effort.

I think the numbers reinforce two things I think most investors already know. If you can get into good hedge funds, like the top 20 in the study but also lots of other funds, they offer great advantages for investors both in diversification and excess return. Institutions that carefully select from good funds have better long-term investment returns with large allocations to alternatives than small allocations to alternatives. But if you pick hedge funds at random, or if you can only get your money into the less desirable funds, you will probably do more good for the managers than yourself, and could easily do worse than you would have from index funds.

This article was originally published by RealClearMarkets and made available via RealClearWire.