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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