November 15, 2005
Hedge Funds, Mutual Funds, 401K’s and Traditional Pensions
Posted by Bill Henderson

Vic has posted some interesting comments (here and here) on hedge funds. Since (a) investments in hedge funds have grown exponentially, (b) the SEC recently enacted new rules for this investment vehicle, and (c) there is a paucity of scholarly literature (at least by legal academics), hedge funds represent a terrific opportunity for young scholars looking for a research niche.

Vic raises the question, “What if the defining characteristic of hedge funds is the compensation scheme, not the underlying portfolio? What are the normative implications?”

According to a detailed SEC Staff Report (Sept 2003), most hedge funds have two financing components: (1) a 1 to 2 percent asset-based investment management fee (similar to mutual funds), and (2) an incentive allocation, which tend to be “20 percent” of “the hedge fund’s net investment income, realized capital gains and unrealized capital appreciation.” Re #2, “high water marks” and “hurdle rates” are contractual terms that reduce the likelihood that a hedge fund manager will profit from poor performance.  The SEC Report suggests (and James Cramer’s entertaining book, Confessions of a Street Addict, corroborates) that the “20 percent / high-water mark” are fairly standard. So I think that Vic is correct that compensation scheme is “a” (or “the”) defining characteristic of hedge funds.

Regarding the normative implications of that observation, I will take off my academic hat and speak only as a concerned citizen.

Just like there are good and bad lawyers or doctors, there are good and bad money managers. It is now obvious that the best money managers are running hedge funds.  Last month, the N.Y. Times  reported that the top money managers for Harvard University quit because their annual compensation would be capped at $20 to $25 million—far below what professionals with similar performance records would earn if they were managing hedge funds (their current jobs). There are countless other stories documenting the migration of the “best and brightest” to hedge funds.

That said, absence a Long Term Capital Management problem, the compensation schemes of hedge funds is an issue that only affects rich people. (SEC rules like Reg D generally prohibit low-net worth people from investing in hedge funds; and regardless, most successful hedge funds require very high minimum investments.) Most of us are stuck in the lackluster world of 401K’s and mutual funds.

I’ll never forget the SEC roundtable discussion in which David Swensen, Chief Investment Officer of Yale University  (whose financial performance has exceeded Harvard’s), heaped derision on the mutual fund world:

[W]e've got thousands and thousands of mutual funds. On average, the experience of individual investors is quite poor there. They would be far better off with an index fund than with the high cost active management that they've got in the mutual fund world. Of the thousands of mutual funds, there are probably several dozen that are worthy of investment.

Okay, Dave, just tell me the top dozen—or better yet, manage my money.

To my mind, the academic debate on the Efficient Capital Market Hypothesis was settled when I saw the gleaming marble floors of Citadel Investment Group, one of the nation’s leading hedge fund managers (note that I was not permitted past the lobby because of airtight security). The longstanding success of hedge funds like Citadel—and there are many others—is clear evidence that supra-normal returns are possible over the long term. Of course, fund managers have zero interest in sharing their trading strategies in order to settle academic debates.

So what is my normative bottom-line?

I worry that the retirement of most Americans depends upon “B” quality money managers at mutual funds. At least with defined benefit pension plans, managers have—in theory, anyway—sufficient resources and negotiating leverage to tap into truly talented investment advisors. Unfortunately, many of these plans are being shed in bankruptcy proceedings (e.g., airlines, steel industry). With the ascendancy of 401K plans and talk of privatizing social security—so more of the Wall Street “B” crowd can collect management fees—I fear we are headed for an economic and political train wreck.

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Comments (14)

1. Posted by Bill Sjostrom on November 15, 2005 @ 19:28 | Permalink

It’s not obvious to me that the best money managers are running hedge funds. The top money managers at Harvard were essentially running a hedge fund at below market rates, so it’s not surprising they left. What are some of the “countless other stories?”

Yes many hedge funds have turned in supernormal returns over the long term but so has Fidelity Magellan and countless other mutual funds. And when you speak of hedge fund returns, are you talking risk-adjusted returns? Obviously, hedge funds take on a lot more risk so with 8,000 out there some of them will have supernormal returns.

If things are really as dire as you say (and I don’t agree that they are), won't the market respond by paying top mutual fund managers more money? While the Investment Adviser Act prevents an adviser from charging a straight performance fee, it does allow fulcrum fees, i.e., fees that increase depending on by how much a fund beats the applicable market index.

2. Posted by Kate Litvak on November 15, 2005 @ 21:17 | Permalink

I am completely lost. Hedge funds /= mutual funds /= pension funds /= university endowments… What exactly are you worried about? And how did the privatization of social security got into this?

Incidentally, managers of _most_ private equity vehicles are compensated under roughly the same scheme (fee plus percent of profits), so it’s can’t possibly true that this compensation scheme is a “defining characteristic” of hedge funds only. It's theoretically possible that there are some minute details that differentiate hedge fund compensation from compensation in other fields of private equity, but we have no data whatsoever on this, and I haven’t even heard a speculation about such relevant differentiating details. This stuff is just plain wrong.

All that was a “normative bottom-line” for what?

3. Posted by William Henderson on November 15, 2005 @ 22:27 | Permalink


I concede your point on the hedge fund/private equity distinction. The compensation scheme could be comparable. So perhaps "a" defining characteristic is more accurate. And you are right: We have no hard data. Just lots of news reports.

But hedge funds, mutual funds, pensions, and endowments all require money managers, and I was merely stating that hedge funds are in the best position to win the bidding war for talent--and most of us don't have access to this investment vehicle. I fear a separating equilbrium may be emerging--the rich get A managers, the rest of us get the B's.


If you believe in markets (and your post suggests that you do), wouldn't you expect the best money manager to gravitate to the market opportunities that provide them with the best return (just like the Harvard managers when Larry Summers capped their pay)?

It does not take long to locate other stories on the migration of talent to hedge funds. Here is one from the New York Times, June 5, 2005.

“[V]ery successful hedge-fund managers make stupendous amounts of money, even by Wall Street's extravagant standards. … ‘Filthy Stinking Rich’ was New York magazine's unambiguous take on the hedge-fund phenomenon some months ago. Last month, in its survey of the best-paid hedge-fund managers, Institutional Investor's Alpha magazine reported that the average pay for the top 25 hedge-fund managers was an astounding $251 million in 2004. …

“Every day, it seems, a half-dozen more young Wall Street hotshots abandon the millions they're making at the big firms like Goldman Sachs or Morgan Stanley and start hedge funds. There are now 8,000 of them, about 40 percent of which have been opened in the last four years, and money is absolutely pouring into them -- they're at $1 trillion and counting -- as institutions search for ways to generate positive returns in this difficult market. Just as business-school graduates once gravitated to venture capital or private equity or dot-coms, now they all want to work for hedge funds.”

Here is another from the New York Times, July 14, 2004:

“Fees for running hedge funds are among the highest in the money management industry, with managers of such portfolios typically receiving 20 percent of any profits, in addition to 1 percent of assets under management. In contrast, mutual fund managers rarely receive more than 2 percent of assets. Veterans of Wall Street investment banks and the largest mutual fund managers have flocked to start their own hedge funds.”

Here is one from the Financial Times (London), July 13, 2004:

"These days, every City or Wall Street investment banker seems either to be starting a hedge fund, or threatening to do so. It is a latter-day dotcom boom: this time, it is not MBA students going to start-ups, but middle-aged bankers."

Or how about this from the Wall Street Journal, Oct. 29, 2004:

“Some investors say they are willing to shift money to hedge funds that buy and hold stocks because these funds have been able to lure some of Wall Street's best stock pickers in recent years. ‘Hedge funds have hired some of the best research analysts on Wall Street; now they're just leveraging those resources,’ says Michael Napoli Jr., managing director of Wilshire Associates in Santa Monica, Calif., which is considering investing in these products.”

That took me about 15 minutes on Lexis and 3 minutes on Factiva. Obviously, there are other similar articles.

Regarding why the mutual funds do not get into a bidding war for better talent (through, as you say, fulcrum fees), I suspect it is because (a) most of their customers cannot flock to hedge funds, and (b) mutual funds will not attract many new customers by giving the equivalent of a 20 percent cut to fund managers (the prevailing rate in the hedge fund world). Again, it is the market.

Finally, Peter Lynch at Fidelity Magellan did have a magnificent run, but his flagship fund was closed for many years to avoid being too big to profitably maneuver. And re “countless other mutual funds” getting supra-normal returns, David Swenson (who is paid like a hedge fund manager) netted a 16.8 percent increase for the Yale endowment during the last 10 years against the 10.8 percent S&P benchmark. Swenson says only a few mutual funds are worth the risk of active management (i.e., likely to net more than S&P after paying fees). I tend to believe him.

4. Posted by Robert Schwartz on November 15, 2005 @ 23:07 | Permalink

"when I saw the gleaming marble floors of Citadel Investment Group, ... The longstanding success of hedge funds ... —is clear evidence that supra-normal returns are possible over the long term."

The only thing that is true over the long term is death and taxes. Just because Citadel hit a home run and splurged on their building means nothing. For all I know, they spent the money in the lobby and went plain pipe rack in the back.

More to the point, hedge funds ride hot hands until they have burned over an area. They have done this in the past (remember when Julian Robertson hung up his spikes) and they will do it in the future.

5. Posted by Robert Schwartz on November 15, 2005 @ 23:21 | Permalink

I should read chronologically. look at comment 9 to Vic' post: Hedge Funds: A Compensation Scheme Masquerading as an Asset Class:

"They seem to find the returns from private equity funds are roughly comparable to the S&P 500 after fees (which are quite substantial) are paid."

6. Posted by Graeme Simpson on November 16, 2005 @ 3:46 | Permalink

Is the fate of defined benefit plans solely in the hands of their fund managers?

The answer has to be "no".

Unless you're faced with a situation where a plan has to secure all of its liabilities, vested and contingent, at the same time, then the performance of a plan's fund manager is essentially just another administrative box for the plan managers to check.

Providing they're keeping up with the majority of asset managers and that your investment profile is approporiate for your plan members demographics it doesn't mean you have an immediate problem.

In fact, surely a market where massive levles of funds as contained in pension pans are switched on a frequent basis is more likely to create market instability with attendant consequences than maintaining a steady, but unspectular innvemstment performance which meets a plan's ongoing needs?

7. Posted by Bill Sjostrom on November 16, 2005 @ 6:17 | Permalink

I don’t disagree that the mutual fund industry has lost some bright people to hedge funds. I guess my problem is the broad leap you take based on reports of bright people flocking to hedge funds that only “B” money managers are left at mutual funds. As for Swenson, he is simply wrong or exaggerating. One minute on will tell you that more than several dozen mutual funds beat the market. As for mutual funds paying more money to attract and retain top talent, they can be competitive without paying the 20% because they have more assets under management. A $40 billion fund can increase the management fee by .25% and have an extra $100 million to use for compensation. Regardless, I don’t think any rational investor would have a problem with a mutual fund manager taking 20% of the profits if the fund is consistently beating the applicable market index. The problem, of course, is that the Advisers Act doesn’t allow for a straight performance fee, only fulcrum fees. Finally, I don’t see the fact that most mutual fund investors can’t leave for hedge funds as a market constraint. There is fierce competition in the mutual fund industry. At the end of the day, all that matters is the funds post-expense return. If a fund can consistently beat the market, it’s assets will balloon even if its paying hedge fund like salaries to its manager.

8. Posted by mb on November 16, 2005 @ 7:49 | Permalink

I don't think hedge funds is (are?) an issue that only affects rich people--at least anecdotally (hat tip to Prof. Litvak) many state retirement systems, as well as TIAA-CREF, invest in hedge funds, and the example of Orange County should show us that those pension systems are not always run by sophisticated managers. I wouldn't worry at all if it was only Bill Gateses who invested in hedge funds--it becomes an issue when the retirement of Iowa school teachers also relies, at least in part, on hedge funds. This isn't really to take a position on either side of the are-hedge-funds-good debate, just to point out that their impact is broader than you're acknowledging.

9. Posted by William Henderson on November 16, 2005 @ 10:51 | Permalink

Re Robert's Schwartz's point on the "gleaming floors" point. Sure, the floors prove nothing. But there is now an entire industry of funds like Citadel that manage huge amounts of capital but are unknown to public. Unlike mutual funds, they don't take out big newspaper and magazine ads. And they are attracting capital _after_ giving 20 percent of the upside to their managers.

The growth in the hedge fund market suggests that that rich people can, in the aggregate, get a higher expected return in hedge funds. Presumably this occurs because of the greater flexibility and superior incentives sytems of hedge funds. When the best managers are baking a bigger pie, both investors and managers can be made better off.

Re Bill's point on Morningstar, fair enough. There are many funds (Swenson said "several dozen") with returns well above the S&P index. See Yet, when you click on the top 10-year performers, you discover that most of them are closed to new investors. Of course, as is often said, past performance may not be a good indicator of future performance--some funds are destined to outperform the market by pure chance. Further, the group average for 4424 funds over 10 years is 6.83 percent, well below the S&P during that same period.

Although there is some trouble with "survival bias" in determining hedge fund returns, the participants in the SEC roundtable (all hedge fund insiders) were very comfortable asserting that hedge funds are just better bets, especially if an investor has sufficient capital to diversify among funds.

Re Mb's point that hedge funds affect regular people through pension funds, I completely agree. But, as I noted in the orginal post, fewer and fewer Americans have traditional pensions. That is a source of my worry.

10. Posted by Brian on November 16, 2005 @ 21:45 | Permalink

Is the SEC meeting next week to vote on even more hedge fund regulations? I ask because the below-linked story seems to imply so, but I can't find any more information. If anyone knows either way, I'd apprecaite hearing about it. Thanks.

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