The HedgeCo Q & A Board provides a forum for parties interested in the hedge fund industry to share information. Questions range from people trying to understand what makes hedge fund different from mutual funds to how to calculate complex statistics for portfolio performance. Here is a summary of five of the most popular questions.
I’m going to post the answer given by Richard Wilson: “Besides the total number of hedge fund managers possibly approaching excess, I would say base management fees run high. They are typically 2% of total funds managed and I think that should come down to 1 or 1.25% or hopefully 0. If you are out there to make money for your investors than take it to the next level and only charge for positive performance.”
However, I would contend that while 2% management fees are high, large amount of the actively managed mutual funds approach 2% management fees, and managed accounts often are much more expensive when you include introducing broker fees.
Rather, leverage is an excess I would like to see fund managers cut back on. Leverage is not categorically risky, but in the past some of the excessively leveraged funds have proved calamitous. Long Term Capital Management provides an excellent example. LTCM took a relatively safe strategy and leveraged it to about thirty times their invested capital. With a leverage ratio of thirty, a 2% loss in the total position means about a 60% loss on capital. It didn’t take long for negative turn in the trading strategy of LTCM to bankrupt the fund.
While options and short positions are inherently leveraged, other types of leverage add unnecessary risk in an effort to increase profitability. But the risk is increased by the same leverage factor as profits.
Yes and no.
Hedge funds are regulated as to who can manage, who can invest, how many investors it can have, how the company is created, basically how the business of the fund is managed.
However, hedge funds have the freedom to invest based on whatever trading strategies it has developed. Also, hedge funds aren’t required to register to SEC, report returns, or disclose their trading strategies.
Proponents of regulating the hedge fund industry are intensifying pressure on legislators to create new regulations that increase transparency in hedge funds. The United States Congress is one of many legislative bodies in the process of developing new regulations on the hedge fund industry. The proposed bill in the United States Senate called the Hedge Fund Transparency Act of 2009 could be voted on as early as the end of this year.
There does seem to be some correlation between assets under management (AUM) and standard deviation of returns, but it is important to look for factors driving the correlation and determine the causation of risk in hedge funds.
Funds with less risk might appeal to more investors and become more sizable. There are less assets in which a large fund can take a meaningful position, and those assets might be less risky. “Too big to fail” is a term that refers to any institution large enough that its failure would affect society as a whole. Institutions that are deemed “too big to fail” warrant government intervention in the event of a failure like the bank bailouts last year.
However, large hedge funds do fail, and some small funds, which contain some risk (like all financial investments) fit the needs of some risk-averse investors. You need to contact an investment advisor to find investments that meet your specific risk profile.
A high water mark is the previous high value of the investment. The fund has to reach this value before the manager can start taking performance fees. For example, if a fund in 2007 was valued at $100 million, and in 2008 lost 20% or was worth $80 million, in 2009, the fund manager can only charge incentive fees once the fund is above the $100 million mark.
Here’s another example: imagine two funds, each with a $1 million in assets with no management fees and a 20% incentive fee. The first fund takes a 50% loss in year one and has a 100% gain in year two, leaving total fund assets at $1 million at the end of year two. The second fund loses 5% in year one and has 10% gain in year two, leaving the fund with $1.045 million in year two.
Without a high water mark, the incentive fee for the first fund in year two is 20% of the 100% gain on $500,000 or $100,000.
The incentive fee for the second fund in year two is 20% of the 10% gain on $950,000 or $19,000.
The fund that produced an overall gain of 4.5% makes 19% of the fund that has flat returns over a two year period. If a high water mark is used, the first fund can’t charge incentive fees, and the second fund charges 20% of $45,000 gain above the original high water mark of $1 million.
The problem with the high water mark is the fund manager whose fund is below the high water mark has incentive to walk away and start a new fund or increase risky trading trying to get back above the mark. The idea of a high water mark is to protect investors but does the exact opposite in application.
Basically, offshore funds offer tax advantages. Most of these offshore funds are set up in countries with low tax rates and are not subjected to US tax laws. Non-US investors are able to avoid US taxes all together, and managers of offshore funds can leave their management and incentive fees in the fund to defer payment of taxes on their income.