Talk of the Town: Hedge Funds
Another New York Times piece on hedge funds in Sunday's paper. Hedge funds, the Times argues, will increase money inflows over the next five year as institutions - like pension plans and endowments -- all look for a piece of the action. But because hedge funds will have more crowds to please, returns could suffer as fund managers tone down the aggresive investing approach that characterize hedge funds. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and bet that stocks will fall, a technique called shorting. And unlike mutual funds, which typically try to beat a market average, hedge funds seek positive returns, even in down markets.Interestingly, the piece revealed that funds have UNDERPERFORMED the market averages over the last decade. So what's all the fuss over hedge funds ? Simple -- they are hard to get into. But that doesn't mean they're better than mutual funds -- whose fees are much less than the bloated compensation structure that has made hedge fund money managers insanely rich, like 500-million-a-year rich. Here's an excerpt in case you missed it:
The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew at an impressive but much slower rate, to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has also grown - to 3,307 last year, up 74 percent from 1,903 in 1999. During the same period, the number of funds created - a manager can start more than one fund at a time - has surged 209 percent, with 1,406 funds introduced in 2004...
...hedge fund experts who pooh-pooh the notion of an investment bubble acknowledge the possibility of a compensation bubble. Instead of just receiving a fixed percentage of the funds they manage, hedge fund managers generally make "1 and 20" - that is, 1 percent of assets under management and 20 percent of profits.
To put that in context, a mutual fund company managing, say, $100 million and earning 1 percent of assets under management makes $1 million. By comparison, a hedge fund making the 1 percent management fee and a 20 percent "carry" takes in $1 million for opening the doors, and an additional $10 million if the fund returns 10 percent. That's $11 million in revenue.
"Hedge funds are an innovation of compensation," said one fund-of-funds executive. "It's a compensation system, not an asset class." The comment is meant to be positive: in hedge funds, compensation is aligned with absolute performance. In the mutual fund industry, by contrast, compensation is usually tied to performance against a benchmark, like a Standard & Poor's index, or assets under management
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