Earn More by Doing Worse: Or, Who’s the Golden Goose of Hedge Funds?

Spurred on by visions of quick wealth, a lot of investors clamor for an opaque class of managed accounts known as hedge funds.

Sadly, though, the punters as a group end up with precisely the opposite of what they had bargained for.

In terms of gross returns, the top tier of hedge funds can more or less keep up with mutual funds. On the other hand, the latter pools are widely known to trail behind the benchmarks of the stock market.

On the other hand, the picture of net gains is left wanting. On average, hedge funds return significantly less to the investors than do mutual funds. One reason for the shortfall lies in the millstone of performance fees for the operators.

The foregoing results apply to the top tier of hedge funds in their prime; namely, the subset of operators who are not shy about disclosing their earnings to public view. The yucky returns do not take into account a clutch of other crucial issues such as the fact that hedge funds bite the dust like mayflies in the spring.

As it happens, even the ablest performers die off in droves. Although the precise results differ from one study to another, a representative conclusion is that the heavyweights in the hedge fund game go out of business at the rate of one-half every five years or so.

Why do the wildcat pools blow up as a matter of course? The main reason lies in the mismatch of reward and penalty between the operators and their customers.

The custodians of hedge funds take a big bite out of the earnings, usually ranging from 20 to 50 percent of the returns, during any period in which the portfolio happens to show a profit. Given the policy of profit sharing, the general public believes that the goals of the stewards are aligned with those of the patrons.

Yet this provision represents only half of the entire arrangement. Sadly, the bulk of investors pay little or no mind to the flip side of the picture.

The downside is the part that causes the damage. When a bet goes sour, the investors take the fall while the principals that caused the flop get off scot-free.

Due to the twisted pattern of payouts, the incentives of the operators are at odds with the objectives of the investors. Moreover, the crummy performance of hedge funds – including their crackups as if they’re going out of style – indicates that the operators as a group do in fact place their own interests ahead of their patrons’.

The purpose of this article is to lay bare the absurd pattern of payouts which results in a face-off between the operators and the investors. As a result, the caretakers of wildcat pools have a habit of taking on batty risks while pursuing their own welfare at the expense of the clients’.

More Booty for Worse Performance

A punter in the financial markets can pump up their bets by taking up some form of leverage. When the winds blow favorably, the plump fruit of a levered bet is a cornucopia of profits.

By the same token, the turnout is a mountain of losses when the currents reverse course as they always do at some point. The upshot is a blowout that ruins the bettor as well as the patrons.

Leverage is the Enemy of Survival

Taking on leverage is a trusty path to a crackup sooner or later. When a portfolio blows up, it doesn’t matter how much money the gamester has made along the way.

A plunger could have racked up millions or gazillions of dollars in profits prior to the bombshell. If the portfolio blows up, though, the whole pile of profits goes up in smoke.

For this reason, a sober investor ought to stay away from dicey schemes involving extreme levels of leverage. High risk is the highway to great loss. That’s the case even for a plain approach that uses no leverage at all.

However, high leverage will lead to total ruin even in the case of a moderate amount of risk. If the portfolio is wiped out, there’s no way to recover from the upset.

Death is Final

When it dies, a portfolio has moved on to the next world forever. Once it’s gone, there’s no way to bring it back. In other words, the game is over for the investor.

Granted, the punter could inject more money into a defunct account and revive the portfolio in a formal sense. On the other hand, the fresh dollop of funds is an extraneous resource that has nothing to do with the original batch of resources.

In other words, it’s a brand-new game altogether. Starting up a new venture does nothing to bring back the assets that have been obliterated in the previous round.

On the other hand, no one ventures into the marketplace in order to lose money. The irony is that the plunger who takes on mounds of leverage in order to get rich quick is bound to end up in the opposite camp. The wildcats will lose their shirts sooner or later.

In a perilous landscape, the prime directive of the investor is to survive. Otherwise, nothing else matters for the luckless player.

Admittedly, there’s no such thing as complete safety. For this reason, taking on risk is a matter of degree rather than category.

Nothing is Fully Safe

In the global marketplace, many people think of debt securities issued by the U.S. government as the safest thing around. Yet, the security is safe only in a legal sense.

The government can print up any amount of cash that it desires. For this reason, the owner of a bond will almost surely get their money back when the security matures.

On the other hand, the investor will receive the payout in the form of cash. Meanwhile, the purchasing power of the dollar is apt to be less in the future than it is at the moment. In fact, it could be a lot less. In that case, the investor will lose money in real terms even when they stick to the safest of assets.

To sum up, there’s no such thing as a perfectly safe investment. Rather, the investor has to take on a modicum of risk in order to grow a nest egg.

Survival is the Primal Goal

While the investor is obliged to take on a dollop of risk, there are sane levels and daft ones. As we noted earlier, the risk should not be so large that there’s a sizable chance of a complete meltdown.

Above all else, the portfolio has to survive the slings and arrows of misfortune in the marketplace. For the death of a pool is permanent.

Given this backdrop, no one in their right mind would take on any form of leverage that could easily kill off an entire portfolio. Yet, this policy assumes that the punter has a keen interest in the survival of the account over the long haul.

Sadly, though, the operators of hedge funds as a group do not fall in that category. In fact, the matchup of reward and punishment is such that the stewards are eager to take on humongous amounts of risk. The bogeys in store are so monstrous that the funds are doomed to perish sooner or later.

Killing Field of Hedge Funds

The more risk the punters take, the larger the slice of the portfolio that they hive off for themselves. That’s the outcome even if the expected performance of the portfolio were to remain steady over time.

In general, taking on more risk will lead to a bigger bonanza for the operators. That’s the case even if the mean return to the investors turns out to be less.

For a newcomer to the hedge fund game, the previous paragraph is likely to be baffling. We know that the custodians are entitled to a percentage of the profits. In that case, how could they boost their income if the investors were to earn less than before?

The plainest way to see how this can happen is to look at a specific example.

A Telling Example

As a starting point, we consider a fund manager named Alex. The gamester enters the forum with a stash of $40 million rounded up from a bunch of investors.

After a year of operation, the gross return on investment comes out to 20%. The latter figure corresponds to $8 million in absolute terms.

In line with a common practice among hedge funds, we’ll take the performance fee to be 25% of the gross earnings. In that case, Alex receives a bonus of $2 million.

For the time being, we assume that there are no other withdrawals or inflows for the hedge fund. In that case, the balance of the profits, amounting to $6 million, is poured back into the pool. After this step, the assets under management stand at $46 million.

During the second year, the portfolio expands in value by 10 percent, or $4.6 million. As a result, Alex receives $1.15 million as a bonus while the investors claim the balance of $3.45 million.

The latter figure is then added to the prior year’s balance of $46 million. In that case, the value of the pool at the end of the second year is $49.45 million.

To summarize the story thus far, the gross profits came out to 20% during the first year, then 10% the next. Over this stretch, Alex earned a total of $3.15 million in bonuses. Meanwhile the overall gain for the investors was $9.45 million.

Gambling with Other People’s Money

Now we consider a cowboy named Bobby who starts off at the same time as Alex with a portfolio of identical size. As a hard-core capitalist, Bobby’s prime objective is to enrich himself.

So he goes on a rampage and loads up on risky stocks. The hustler also dabbles in the futures market in order to control a stake that exceeds the value of the portfolio by a factor of 10 or more.

Thanks to the risky bets, the portfolio soars in value by 90%, or $36 million, during the first year. Based on a performance fee of 25% of the profits, Bobby’s piece of the action comes out to a cool $9 million.

The remaining portion of the spoils is claimed by the investors, who plow the bounty of $27 million back into the fund. At this stage, the portfolio is worth $67 million.

During the second year, though, some of the bets go terribly wrong. In spite of Bobby’s frantic efforts to reverse the losses, the portfolio tumbles by one-half from its value at the start of the year. After losing 50% of its value, the portfolio shrivels to $33.5 million.

In relative terms, the magnitude of the loss is only a fraction of the gain during the prior year. To be precise, the turnout of negative 50% in the current year is comfortably smaller than the gain of positive 90% raked in during the first year.

Yet, the relative figures can be misleading. In absolute terms, the recent loss of $33.5 million doesn’t differ a great deal from the gain of $36 million garnered during the first year.

And poor Bobby: since the fund lost money, he gets no bonus at all during the second year. Of course, he still gets the fixed stipend for administrative fees, which is apt to be 2% per annum on the average value of the portfolio each year.

For Bobby’s fund, the balance was $67 million at the beginning of the second year, and half that amount at the close. To keep things simple, we will assume that the average value of the initial and final figures was in fact the mean balance over the course of the year. In that case, the average value of the pool comes out to $50.25 million.

Since the administrative charge is 2% of the average balance, Bobby still gets to keep a little over $1 million to cover the cost of office space, wages and other expenses. That’s not a bad payout for somebody who has turned in an execrable performance.

Let’s sum up the results for Bobby. His fund gained 90% during the first year, then lost 50% during the follow-up.

Over the 2-year span, the investors’ equity slumped from $40 million to $33.5 million. The loss of 16.25% does not even take into account the maintenance fees, in excess of a million dollars each year, paid out to the operator.

Over the entire period, the patrons of the ill-fated pool lost $6.5 million. By contrast, Bobby earned a total of $9 million thanks to the whopping bonus during the first year.

How does this payout compare with Alex’s lot? The steady earner turned in a gain of 20% the first year, followed by 10% the next year.

In absolute figures, the portfolio rose from $40 million to $49.45 million over the 2-year stretch. In other words, the investors earned nearly $9.45 million, or roughly 24%, over this stretch. We are of course ignoring the couple of megabucks paid to the custodian in the form of administrative fees.

Over this period, Alex enjoyed a total of $3.15 in bonuses. In other words, he earned one third of the amount garnered by the investors.

The distribution of payouts comes as no surprise during a period marked by steady earnings. In other words, the ratio of 1:3 indicates that the steward took in one-quarter of the profits.

To round up, the final reckoning is as follows. The patrons of Alex’s fund enjoyed steady gains over the 2-year period. Meanwhile those in Bobby’s camp had to suffer through a nauseating ride and ended up losing a pretty penny to boot.

In spite of the atrocious results, Bobby earned $9 million: nearly thrice the payoff for his demure counterpart Alex. This example illustrates the fact that it pays for an operator to take on mounds of risk even if the investors get clobbered as a result.

That is the loony consequence of the twisted matchup of reward and punishment in the hedge fund game. For the custodian, looking after the clients’ welfare is not the way to snag the big bucks.

On the contrary, piling on heaps of leverage along with the risk to match is the name of the game for the operator. The more risk they take, the more money they make. The flip side is that the investors end up getting fleeced.

Given the batty lineup of incentives and the gambling that it promotes, it’s no surprise that hedge funds go out of business in droves regardless of sunny weather or heavy downpours in the marketplace. The gross rate of mortality in this neck of the woods is a logical outcome of the crooked pattern of payouts.

Good Guys Finish Last

Looking at the larger picture, the morass of hedge funds is not a place where investors go to get rich. Rather, the field as a whole is a crucible where money is transferred from savers to operators under the cloak of legality.

Granted, there may be a cadre of civic-minded souls in the arena who make an earnest effort to place the interests of the investors on a par with their own. As we saw in the foregoing vignette, however, the principled characters of this breed will not make much money compared to their gung-ho rivals.

Moreover, the actual performance of hedge funds indicates that the practice of the art falls in line with the dictates of sheer logic. The flaccid returns of hedge funds in the aggregate, along with their grisly rate of mortality, shows that the setup is a losing game for the customers.

In this milieu, the only real question is how quickly the pools blow up. If the investors are lucky, a particular outfit will chug along for years or even decades before it breaks down and falls apart.

Will the customers lose their shirts now or later? In an abstract sense, the timing of the meltdown is relevant to the patrons.

In actuality, though, the response is unlikely to make any difference whatsoever. The reason is as follows.

Instant Loss

If the hedge fund game is a losing proposition for the investing public, then an interesting question is how quickly the money is lost. In a formal sense, the money goes poof when a portfolio goes kaput.

The same is true in a legal sense. The loss is recognized in accounting terms when the assets break down.

Here is a case, though, where the practice is at odds with the theory. In a practical sense, the investors lose the bulk of their capital as soon as they transfer the funds over to the operators.

For every investor that takes out some or all of the earnings out of a pool during a profitable spell, there is apt to be at least one more that puts in even more money into the hedge fund. For this reason, the outfit is likely to suck in even more money when the winds blow in its favor.

From the standpoint of the patrons, the money that was committed is unavailable for other projects. When a hedge fund finally does blow up, the takedown of the portfolio is a permanent condition.

In a practical sense, then, the bulk of the capital put in by the investors is lost to them as soon as they hand over the cash. For this reason, it makes no difference in a real sense whether the hedge funds crack up in short order or after a long stretch.

To sum up, the timing of the blowup is wont to be immaterial for the customers of hedge funds. As a group, the patrons should kiss the money goodbye – in whole or in part – as soon as they hand over the dough.

Moral of the Story

The crux of the problem in the hedge fund game lies in the lopsided pattern of reward and penalty. When the currents in the marketplace run in the right direction, the operators can make out like bandits.

When the tide turns, as it always does at some stage, the stewards are untouched by the drubbing. In the wake of a washout, only the investors get soaked.

It’s a poignant sketch of human nature that the parable of the golden goose should apply so widely to the financial forum. The cast of characters at center stage include the troupe of hedge funds both large and small.

The overreaching players may take the form of boutique outfits calling their own tunes. Or they could be rabid groups nestled within larger organs such as commercial banks and insurance firms.

In a common version of the fairy tale, the gifted goose would an egg of gold once a day. However, the owner of the fowl was not content to prosper at a measured pace. In a futile move to get his hands on all the eggs at once, the brute butchered the staunch creature.

Naturally, the outcome was far from what the bungler had pictured. The dead goose was in no shape to serve up any eggs at all.

No doubt the caretakers of hedge funds are well aware of this fable and the lesson it conveys. If that’s the case, then why would the operators in such large numbers take up a course of action that leads to the blowup of the pools in their custody?

The only credible explanation lies in the prospect of additional geese. If a given fund falls flat, the pool busters can go off and start up another scheme in a different niche.

The stratagem may work just fine for the operators, but the results are hardly satisfactory for the investors. In this setting, we can only presume that the majority of prospects are unaware of the true role they are meant to play in the hedge fund game. Like it or not, the patrons as a group end up serving as the golden geese of the financial pen.

That’s something to think about for any punter who gets an urge to jump into the ring. According to the rules of the game, the odds are stacked against the investors behind hedge funds.