January 18, 2006
I've always pushed myself to stay current, and now that I'm a newly minted 50-year-old, I work at it even harder. There's no Eagles' Greatest Hits in my music collection. It's the New Pornographers and Metric on my iPod. I use a BlackBerry, a Bosu balance trainer, read blogs and leave my T-shirt untucked.
But when it comes to the hedge fund debate, I find myself being categorized as a dinosaur. It's a bit unsettling, but not necessarily a bad thing. Some great investors have worn the dinosaur label and lived to tell about it. Bob Krembil and his Trimark team were in that category in the late nineties and Warren Buffett gets accused of it from time to time. I've lived with it before, myself. In 1999, a client of my old firm, Phillips Hager & North, told me our approach wasn't relevant any more.
I'm of the view that hedge funds won't survive in their current form.
I don't have a problem with the way hedge fund assets are managed. Indeed, I think it's the way of the future. What's not to like? Scary-smart people using the latest technology to seek out the best opportunities in capital markets. When they find good ideas, they pursue them aggressively, unconstrained by the rules and regulations that apply to a mutual or pension fund.
As an investment product, or package, however, hedge funds don't make sense. I'm referring to the fact that these funds carry a high fee and have no safeguards to protect the investor. The standard fee schedule for hedge funds is a 2-per-cent management fee plus a performance fee, which is typically 20 per cent of the annual return.
Two and 20, as it's affectionately known in the industry, applies if you invest directly with an individual manager. If you want to diversify, then you'll want to invest in a fund of funds, which has many managers and strategies under its umbrella. An FOF manager usually charges another one and 10, so you're now up to a 3-per-cent base fee with 30 per cent of the return going to your managers.
There is a good and bad side to two and 20. The good news is you only pay an exorbitant fee when the performance is good. The bad news is that even the minimum fee is high. The manager may not get rich on 2 per cent, but he or she won't have to sell the Porsche or take the kids out of private school while waiting for the next big payday.
And you should know that this is virtually an unregulated industry and the management agreements I've read have been tilted heavily in favour of the manager.
Why am I so bearish on hedge funds? In a nutshell, I don't think these talented managers can earn high enough returns to support the compensation structure. We are now living in a 4-per-cent interest rate world. That's what 10- to 30-year government bonds yield. If we assume that to be the risk-free rate for long-term assets, then any return above 4 per cent represents a risk premium. As with any risk-taking exercise, there will always be managers who rise above the crowd and achieve high returns. But, in all likelihood, we are heading into a period where returns from the capital markets will be lower and the odds are that many more managers won't be able to justify the fees they're charging.
Along with low interest rates, we also have a flat yield curve, meaning short-term interest rates are similar to long-term rates. While this situation persists, the hedge fund industry loses one of its most common and reliable strategies, which is to borrow short and buy higher-yielding, long-term assets.
Lower returns aren't the only challenge the hedge fund industry faces. The managers are also swimming against a wave of new dollars. What was a few hundred billion dollars a couple of years ago, is now a trillion. That means there are many more managers, with many more dollars, pursuing the same strategies. If you talk to people in the industry that are doing fixed-income arbitrage or merger arbitrage, they'll tell you that the math doesn't work on their trades like it used to.
With all these assets to manage, there is also a wave of young professionals coming into the hedge fund industry. Some of them truly are math wizards or rocket scientists, but many are not. Today, there are plenty of average practitioners pretending to be high-octane hedge fund managers.
Exorbitant fees. A lower return environment. A flat yield curve. Lots of new money flowing in. A diluted talent pool. For me, it all adds up to a trend that is not sustainable.
Am I a dinosaur? Time will tell. In the meantime, I'm going snowboarding.
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