Peter J. de Marigny
is Portfolio Manager of DITMo® Strategies, an Equity Hedge, Aggressive-Income Objective, Buy/Write Portfolio for an Aggressive-Income Objective used as an Enhanced Cash investment vehicle. Pj is also Head of Risk Alternative Strategies for Newport Beach, CA advisor Renovatio Asset Management.
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Jesse Marrus
Jesse Marrus is the Founder and CEO of StreetID, a financial career matchmaking, news and networking site. He has unique insight into the financial services job industry including career advice, employment trends, fund formations, layoffs and hiring developments.
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Rashida Fleet is involved with consulting and working with managers during the fund launch phase. Her work includes; interviewing managers, collecting information for the HedgeCo database and contributing to the HedgeCo News feed.
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Tim Seymour is co-founder and managing partner of Red Star Asset Management, as well as Chief Operating Officer of the $116 million Red Star Double Alpha Fund. » View Tim Seymour
Richard Heller Richard Heller is a partner at the New York City law firm of Thompson Hine LLP. His experience is in the formation of private offerings for hedge funds as well as the formation of registered broker-dealers and RIAs.
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Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and President of Alpha Theory™, a Portfolio Management Platform designed to give fundamental money managers the ability to create their own repeatable discipline to organize the complex process of portfolio management.
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Lost in the shuffle of the recent economic crisis, American financial institutions now have the opportunity to service clients of their now-failed counterparts. No where has this been more evident than the world of hedge fund prime brokerage. When Lehman Brothers and Bear Stearns failed, the rest of the banking industry went into defense mode and began to cut servicing to riskier or less profitable hedge fund clientèle. Hedge funds were losing money anyway, and prime brokerage departments couldn’t fathom spending time, effort, or money to service these smaller, less-conspicuous hedge funds.
Now, hedge funds are roaring back, and many new prime brokerage departments are opening to take advantage of the availability of new or formerly-undesirable prime brokerage clients. According to Jenny Strasburg of the Wall Street Journal, FBR Capital Markets and Cantor Fitzgerald &Co. have both added prime brokerage units in the past few months. Conifer Securities began servicing prime brokerage clients in January, Merlin Securities opened its prime brokerage department in 2004, and Jeffries & Co. launched prime brokerage in 2007.
While these new prime brokerage departments are operating in relative obscurity, they are doing big business with hedge funds with less than $500 million in AUM. In 2007, analyst estimated the prime brokerage market to be worth more than $10 billion, and these new firms are poised to take in clients that can’t find servicing from the major brokerage houses like Goldman Sachs, Morgan Stanley, and JP Morgan. At the end of the day, Wall Street is an eat-what-you-kill industry, and the big boys are leaving a lot more than scraps for the smaller brokerage houses to fight over.
In the wake of one of the most severe liquidity crises in recent memory, the vast majority of hedge fund managers have seen their assets under management shrink considerably over the past twelve months. Whether in the name of paring back on risk, exiting losing positions, reducing portfolio volatility, or simply rebalancing portfolios, investors have used a litany of reasons to withdraw several hundred billion dollars in capital from their hedge fund accounts. This, in turn, has drastically shrunken managers’ ability to generate fees on these accounts. As a result, hedge funds are increasingly reworking their fee structures in order to satisfy existing investors, as well as attract new capital to their funds.
Let’s start out with a primer on the basics of hedge fund fees structures. Hedge funds typically earn their income through a variety of fee structures charged to their clients. These fees are not only meant to cover fund administrative and operating costs, but also to reward employees and managers for providing positive returns to investors. The most common and well-known hedge fund fee structure combines both management and performance-based fees.
First, the “management” fee represents an annual, base fee levied on the amount of assets managed by a firm. This fee can represent anywhere from 1-4% of net assets, however 1-2% is the most common range. Thus, as an example, if a hedge fund has a management fee of 2%, then investors are charged $2,000 for every $100,000 invested in the fund, per year. However, rather than being levied on the investor as one flat charge, management fees are usually deducted incrementally, on a monthly or quarterly basis. These fees are traditionally used to cover fund administrative and operating costs, which may range from paying a full-time staff or third party administrator, to renting office space or attending conferences.
The second common fee structure within the hedge fund industry is a “performance,” or incentive-based fee. Performance-based fees, on an ideological level, are intended to properly align the interests of the fund manager with investors. The fee, which represents a percentage of the year’s profits, is thus only awarded to the manager in the event that he provides positive returns to his clients. Performance fees typically range from 10-40%, however 20% appears to be the accepted industry norm. Often, these fees are allotted to firm employees and managers in the form of bonuses, used as a way to reward positive performance by managers on behalf of their clients. Hence, when a hedge fund’s fee structure is referred to as “2 and 20,” this means that it charges a 2% management fee and a 20% performance fee.
Increasingly in the past year, hedge fund managers have moved to reduce these fees in order to appease investors (after all, fees generally reduce investor returns). Some managers, such as Bill Ackman, have vowed to halt the charging of fees to existing investors until previous fund losses have been reversed. Oftentimes referred to as the implementation of a “high water mark,” this is typically done to appease existing investors who may feel jilted due to excessive fund losses. It essentially prevents managers from charging double layers of fees.
Meanwhile, support is mounting for funds to abandon the traditional “2 and 20″ fee structure. A recent report by Barclays Capital suggests that a growing number of investors favor the implementation of “hurdle rates,” which prevent managers from levying annual performance fees until they have met and passed a predisclosed benchmark performance rate. This would hold managers more accountable, as they would only be rewarded for posting returns in excess of, say, the risk free rate. Additionally, some managers are facing pressure to lower all fees in order to attract new investors. For example, investors, particularly in the pension fund industry, are beginning to seek out funds with lower expense ratios, such as a “1 and 10″ structure. These lower fee funds help to better-preserve investor capital, especially during years of negative fund performance.
The combination of charging both management and performance fees should continue as an industry-accepted standard. While the management fee is used to cover basic fund expenses, the performance or “incentive” fee properly aligns the interests of the manager with his investors. Furthermore, while hedge fund assets under management have fallen considerably over the past year (recent estimates put the value at about $1.3 trillion under management, down from an estimated $2.5 trillion), potential investors actually wield a considerable amount of power. As investors reenter the hedge fund arena, managers may be forced to make concessions in order to win back their hard-earned capital, not to mention their trust.
In the coming years, it will be interesting to gauge whether investors, indeed, pressure the entire industry into lowering its fees. In my opinion, managers will be willing to make concessions on fees in the near term. In fact, investors would be wise to make these demands while the hedge fund industry is scaling back, and perhaps in its most vulnerable state. If investors demand incentives to return to hedge funds, retooling fee structures represents a logical starting point.
That being said, investors need to make those demands right now. If they fail to act now, then several years down the road, as industry-wide returns stabilize and improve, investor uproar over fees will likely evaporate. As a result, investors seeking concessions would be wise to strike while the proverbial iron is hot. If not now, then when?
We received an interesting question from one of our members earlier this week:
“I was wondering if someone could give me an idea of where hedge funds are on the totem pole as far as risk with intangible investments. My guess is that they rank with growth mutual funds and are less risky than stocks but I would like a more descriptive census of where they stand amongst stocks and mutual funds.”
Hedge funds are uniquely difficult to assign risk profiles because they employ many different strategies. Some hedge funds buy up illiquid assets when liquidity is at a premium, and these assets are selling at pennies on the dollar. In some situations, the fundamentals are still very sound, but the hedge funds are purchasing the assets at a deep discount further lowering the risk and raising the potential return on investment. When done properly, this strategy is low risk and similar to a corporate bond fund. Other hedge funds will invest in highly speculative strategies, specializing in risky assets like distressed debt and emerging market equities, or risky derivatives like commodity futures. These strategies tend to have risk profiles similar to investing in individual stocks, but better managers will be able to reduce risk and stabilize returns to a degree.
To develop an accurate risk profile for a specific hedge fund, investors need to gather as much information about the underlying assets and fund strategy as possible. Usually, investors only have access to the types of assets used, but increased transparency in hedge funds is the current trend, and hedge fund managers will probably start disclosing more and more information about their trading positions. For each strategy, certain levels of risk are inherent, and remember that leverage increases risk just like returns. While strategy will tell investors a lot about the hedge fund’s risk profile, implementation of the strategy is another important piece to hedge fund risk.
Therefore, investors have to develop a risk profile of the hedge fund manager. This profile should include information about the manager’s historical performance for all his funds, including statistical analysis that measure standard deviations, maximum drawdowns, downside deviations, and all the risk-adjusted return ratios like Sharpe and Sortino ratios. Particular attention must be paid to the hedge fund manager’s performance in similar strategies to the fund of interest. Investors need to identify how the fund manager performed when using a “low risk” strategy or a “high risk” strategy.
Lastly, investors need to inspect the fund’s infrastructure. Check to make sure the hedge fund is using high quality third party administration, legal advice, auditing services, and brokerage services. Performing due diligence on a fund’s infrastructure goes a long way towards identifying counter party risk and preventing fraud
I’m pretty sure my answer to the above question is a little more technical and in depth than what was asked for, but the point is that hedge funds can’t be fitted to neat little risk profiles or mutual fund style boxes. However, hedge funds were originally designed with the intention of preserving capital for the ultra-wealthy. Because the hedge fund manager ultimately has control of the fund and can utilize in style he deems appropriate, he is the key differentiator in measuring risks of hedge funds and risks of other investment vehicles. So, my short answer is hedge funds are as risky as the hedge fund manager wants them to be.
Evan Rapoport, Co-Founder of HedgeCo Networks, has been blogging up a storm over at his Capital Introduction Blog.
Borrowing from years of experience raising capital for hedge funds and other institutions, Evan takes a very direct and knowledgeable approach to navigating through the often tricky waters surrounding marketing your hedge fund.
First, the basics. What is hedge fund third party marketing? Third party marketers (3pm’s) are essentially hedge fund brokers. They represent various hedge fund products and introduce and sell these products to qualified investors. As a result of the introduction and follow up by the marketer, if an investment is made, the 3pm gets compensated. Usually compensation comes in the form of a portion of fees. The ‘standard’ 3pm fee is 20/20. That is, twenty percent of both the management fee and the performance fee. This is usually paid to the 3pm’s brokerage firm as the fund receives its fees, and is usually paid to the marketer for the life of the client.
Where does a hedge fund manager find third party marketers to market their hedge fund? The Third Party Marketers Association (3pm.org) estimates there are about 500 third party marketers in the United States. Not very many, relative to the amount of hedge funds that are out there. There are several firms like mine, HedgeCo Securities, that are set up to exclusively market hedge funds. You can find these firms by searching some of the various hedge fund website service provider directories, or by looking at 3pm.org. Keep in mind, with some 10,000 estimated funds, and only 500 3pm’s, it is easy to realize why 3pm’s have a reason to be picky. So if you are a hedge fund that is less than 10-25 million (and I am being very generous here), don’t be surprised if you do not find a third party marketer to represent your fund…
Evan Rapoport also wrote a 3-part series on Hedge Fund Administration and how it not only is necessary for the running of a hedge fund, but is also crucial for your investors and your marketing efforts. This series is a must-read for investors and hedge fund managers alike.
HedgeFund Intelligence’s Press Release from today states that the fund of funds industry shrank by $95 billion in the first half of 2009 but still manages $735 billion.This represents a decline of 11.4 percent in assets under management (AUM).Firms with more than $1 billion in AUM manage a combined $613 billion.According to HedgeFund Intelligence, 18 fund of hedge funds companies have been removed from the InvestHedge Billion Dollar Club (list of firms with $1 billion or more in AUM).Recently, we listed the top 50 fund of hedge funds firms and found that the top 50 firms manage $489 billion.
While the fund of hedge fund industry has shrank over the past year, investors are looking at the decline as a culling of the herd.The better funds of funds have survived the economic turmoil and are ready to take on new investors and identify promising hedge funds.
Many economic analysts and pundits don’t believe we are going to see prolonged aggressive bull financial markets going forward.Rather, investors will be dealing with volatile conditions and unstable markets domestically and abroad.The superior fund of funds managers will have to shrewdly identify hedge fund managers using strategies that capture positive returns while reducing downside deviations in volatile markets.
Furthermore, fund of hedge fund managers will have to be judiciously observant of the infrastructure of fund managers to avoid fraudulent situations that have recently plagued the hedge fund industry and avoid the Bernie Madoff’s of the world. Perhaps, the steady fund of hedge funds managers can be the stabilizing force that returns respectability to the hedge fund industry.
While the debate rages on as to whether the economy is, indeed, displaying evidence of “green shoots,” numerous hedge fund firms appear to be taking matters into their own hands, repositioning themselves to benefit from any signs of improving investor sentiment. In particular, several firms have gone on recent hiring sprees in an attempt to lock in the best and the brightest minds from the considerably large pool of unemployed hedge fund workers.
Recent struggles within the hedge fund industry are well documented. In addition to the estimated 1,500 funds which were forced to close in 2008, a vast majority of funds experienced a significant fall in assets under management. Unable to generate substantial profits from fee generation, this forced numerous firms to cut expenses and/or lay off workers. However, a renewal in industry hiring could signify optimism amongst some of the industry’s major players.
As the markets rebound from their lows of the past year, once-wary investors are beginning to retest the markets. Repositioning themselves for an impending rebound, many firms are actively raising capital, while adding staff to fill sales and marketing roles. In fact, Citadel, RBC Capital Markets, Artradis and Tribridge have all announced recent hires.
Furthermore, the prime brokerage business, which offers fund managers a variety of services ranging from clearing to securities lending to financing services, is another area experiencing growth. Firms such as Credit Suisse Group AG and BNP Paribas SA, in particular, have announced their plans to expand prime brokerage services. This expansion is especially pronounced in Asia, where the region’s hedge fund industry is expected to resume its prolific growth.
Hedge fund hiring by some of Wall Street’s biggest players could also signify to makings of a turnaround for the hedge fund industry. Citigroup Inc. and Bank of America Corp.’s Bank of America Merrill Lynch have also added new hires to their hedge fund businesses. Meanwhile, in one of the largest hiring moves to date, Morgan Stanley announced late last week its intentions to add 400 new hedge fund hires in areas ranging from sales to trading.
Recent hiring patterns would suggest that hedge fund firms are retooling their infrastructure, positioning themselves to benefit as investors return to the industry. In the process, this news perhaps offers a glimmer of hope to the throngs of idle and out-of-work former hedge fund employees.
I recently wrote an article on the emerging markets across the globe, and looking at the charts of performance for each country, I couldn’t help but notice one thing. While magnitude of volatility varied from country to country, every chart had the same shape. Every trend line moved together. MSCI Barra provides charts of the individual emerging markets based on the listed equities of each country. Each emerging market was booming up until 2008, took a sharp decline in the middle and end of 2008, and bounced back at the beginning and middle of 2009, which probably isn’t surprising to anyone reading this. “Some of emerging markets hedge funds were down almost 50 percent,” according to Andrew Schneider, managing partner of HedgeCo Networks. “Take the Tarpon All Equities Fund for example. They lost 43 percent in 2008.” While this type of volatility is expected in the emerging markets universe, fund managers and investors don’t have to withstand these massive losses to access the spectacular gains of better years.
The Emerging Markets Market
Because each country’s equity market moved in such a similar pattern, I began to think we could start looking at the whole basket of emerging markets as a unique market, like the US equities market. The broad movements imply market or systematic risk. When the emerging markets market (EM market) moves, individual emerging markets face pressure to move in the same pattern.
The movements of the emerging markets as a whole are mainly due to foreign investors’ capital moving into and out of the EM market based on the perception of emerging countries in general or as emerging market investors’ capital is fluctuating, which was the case in 2008. Investors in developed countries lost money domestically and liquidated their foreign holdings. These types of fluctuations are artificial, since a country’s economy does not become less productive and innovative just because foreign investors are pulling out capital. I would equate these artificial movements to a stock that loses ten percent market value when it misses its earnings forecast by a penny.
Despite a series of ongoing challenges, a variety of environmental effects have recently swung in the activists’ favor. First, as mentioned in my previous blog post, stock prices have taken a tremendous hit over the past year. Yet while the news media tend to tout the market’s recent resurgence, in reality the S&P 500 still remains more than 25% below its level of one year ago. This has unlocked a variety of value opportunities for investors, and activist hedge funds have taken notice. In Ackman’s case, it has allowed him to add considerably to Pershing Square’s stake in Borders Group (its current economic interest consists of 40% of shares outstanding), as well as earn him a seat on the company’s board. In doing so, he has lowered his investment’s average cost basis by purchasing shares at lower prices, thus setting the stage for a substantial profit opportunity if and when the book retailer’s shares rebound.
In addition, activist investors are benefiting from a recent groundswell of support for corporate governance reform, following a rise in publicity over corporate excesses. Corporate carelessness and excess, which includes outrageous bonus payouts and golden parachute provisions paid out to management, as well as the stacking of corporate boards with the close friends of leadership, essentially robs shareholders of their right to share in a firm’s success. In one more egregious example, Robert Nardelli received a $210 million severance package from Home Depot in 2007 as its departing CEO; yet, during his six years with the firm its share price failed to appreciate in any meaningful way.
In response to such corporate excess, a variety of changes are in the works. In July, the SEC enacted a series of proposals aimed at corporate transparency, such as allowing shareholders of companies participating in the Troubled Asset Relief Program (TARP) to vote on executive pay. In addition, the SEC is now considering reforms intended to “remove impediments so shareholders may more effectively exercise their rights under state law to nominate and elect directors at meetings of shareholders.”
Reuters reports British pension funds are joining the battle against European Union’s proposed regulations on the hedge fund and alternative investment universe. The National Association of Pension Funds (NAPF) and a director at Hermes, manager of the largest corporate scheme in Britain, said the rules could restrict investment choices and returns, further affecting the ability of pension funds to provide ample returns to support the aging population.
The current draft of legislation would require hedge funds to register and disclose leverage levels, according to Reuters. Furthermore, non-EU managers would be restricted in sales of funds in Europe. The Alternative Investment Management Association (AIMA) estimates could create a 25 billion euro hit for European pension funds and as much as 2.5% decrease in returns. We are seeing attempts at regulating the hedge fund industry across the globe with proposed legislation by the US Treasury. Hedge funds have successfully lobbied to keep these types of regulations from affecting the industry in the past, but mounting pressure from legislators and their constituents is on the rise due to failures of funds and fraudulent fund managers in recent years.
Investors would benefit from registration of funds requiring leverage ratios and returns to be disclosed along with risk statistics. As failures and fraudulent managers gain media attention, look for proposed regulations to gain traction with legislatures.
Philippa Aylmer, contributing editor to The Hedge Fund Journal, writes, “If the last decade could be described as the biggest credit party ever, then the end of 2008 brought the mother of all hangovers. The hedge fund industry took a beating along with much else in the financial services sector and funds of hedge funds felt their share of the pain.”
The Hedge Fund Journal‘s report of the “Global 50: Funds of Hedge Funds” shows the decrease in assets under management in funds of hedge funds from September of 2008 to June 2009. With the market downturn and the uncovering of Madoff’s $50 Billion ponzi scheme, funds of hedge funds had been hemorrhaging AUM in 2008 but have slowed the bleeding in the early part of 2009. Will the fund of hedge funds recover from their wounds by the end of this year, or will it take more time? We will have to wait and see.
Here are the top 50 fund of hedge funds groups ranked by assets under management as of the end of June in 2009.
The current draft of legislation would require hedge funds to register and disclose leverage levels, according to 
