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My Favorite Hedge Fund: Part Two
Chicago, IL
Friday, February 15, 2008
Janet Tavakoli, president of Tavakoli Structured Finance, Inc.
MY FAVORITE HEDGE FUND: Part Two
By Janet Tavakoli
Desperate times call for desperate measures. Teetering on the brink of bankruptcy qualifies as one of those times. Although the ownership partners of Long Term Capital Management acted as fiduciaries for outside fund investors, they borrowed US$38 million from the fund to pay the salaries of their own employees. It was contractually allowable, at least according to Roger Lowenstein's book When Genius Failed. The partners worried that if they didn't pay employees, they would quickly lose them, and they were probably right.
Hedge fund investors include high-net-worth (mere multimillionaire) and ultra-high-net-worth (more than US$30 million) individuals. The problem is that many managers and employees of smaller hedge funds are not as wealthy as the investors, but they aspire to the high altitudes of their customers. After all, they reason, if they are taking the risk of working for a hedge fund, they should get paid for it.
How much should hedge fund employees get paid? Senior risk managers at investment banks get paid in the high six figures. A well-known bank just hired a second-tier compliance officer for $800 thousand per year. Structured credit researchers get paid anywhere from the high six figures to $1.3 million per year. A mediocre senior investment banker will earn around $2 million per year, and a good one can earn much more. But many beginning hedge fund managers—much less the rank and file employees—can only aspire to this compensation.
Yet hedge fund managers have faith that they will reach the big leagues. Institutional Investor's Alpha magazine (as quoted in the June 5 New York Times Sunday Magazine) reported that the average pay for the top 25 hedge fund managers in 2004 was $251 million. But that is for the top 25 mangers in a field of 8,000—800 of which will fail, while many others will barely scrape by this year.
Smaller hedge funds often rely on their prime brokers for risk management and trade ideas. Even so, they tend to drastically underestimate the cost of doing business. Fortunately for hedge fund managers, the fees they charge can add up faster than the miscellaneous charges on a cell phone bill. Nominal fees commonly include 2% of portfolio value and 20% of the upside. But hidden fees can be rolled in as administrative costs and hidden commission payments to investment banks. If the hedge fund documents allow loans to management, the moral hazard compounds.
Some organizations charge fees to vet hedge funds for high net worth individuals, but if you are a regular reader of hedge fund news, you probably realize that outside experts may not have better opinions or better information than you can glean on your own.
Who can you trust when it comes to your own money? No one. That means you have to be prepared to ask better questions.
TAVAKOLI'S LAW: IF SOME HEDGE FUNDS SOAR, SOME MUST CRASH AND BURN
You cannot be more diversified than the market portfolio. If you go long and short market assets, the mix does not become more diversified. Hedge funds have not created new asset classes. They simply trade in global market assets.
The stock market offers a simple way to look at this. Together, passive and active investors own 100% of the global stock market. The average return of all passive and active investors together is exactly equal to the average return of the global market. The average return of passive investors, the indexers, is also equal to the average return of the global stock market.
This means that active investing is a zero-sum game. Given that passive investors' return is the average, active investors must also have the same average return as the global market, before fees, before expenses, and before taxes. If some hedge funds wildly outperform the market, as some of the largest claim to do, other hedge funds must spectacularly underperform. Fees, expenses, and taxes just make the spectacular underperformance even worse.
I am treating individual active investors as if they were individual hedge funds and as if their average returns were at least as good as the average returns of hedge funds. I do not buy the argument that on average individual active investors under perform hedge funds. It is even possible that individual active investors outperform hedge funds after one adjusts for creation bias, survivorship bias, fraud, other misleading methods of reporting returns, and high fees.
The already large flow of money into hedge funds is accelerating. Some estimates claim that funds under management have tripled to almost $1 trillion since 2003. The overcrowding is making most hedge fund strategies look very unattractive. Many hedge funds are merely shorting (selling) volatility to earn risk premiums—selling options in a low implied volatility environment and selling credit default protection in a skinny credit spread environment—trying to hedge away the fat tails of risk. Underperforming hedge funds resort to leverage in a gamble to inflate returns.
CREATIONISM VERSUS EVOLUTION
The barriers to entry into the hedge fund world are low, and there seems to be a philosophy in the hedgosphere that "anyone can do it." It seems all it takes to go from zero to hero is swagger and loudly trumpeted claims.
Much is made of the distortion in hedge fund indexes due to survivorship bias, the fact that failed funds drop out of the equation. Creation bias is probably a larger problem. Only "successful" funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial out-performance has a halo effect on later years, since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre.
Rapid growth can be a problem for the new creations. As money flows in, the funds often cannot replicate out-performance and devolve into underperformers. If one uses weighted average returns—weighted for funds under management—the picture is dismal.
BENJAMIN GRAHAM'S HEDGE FUND
My favorite hedge fund is still my own. Benjamin Graham, author of Securities Analysis and The Intelligent Investor, was the most influential investment adviser of the 20th century. I like to think that Benjamin Graham's favorite hedge fund would look something like mine. The after-tax returns beat most hedge funds. I trust the management and keep the overhead low. I have no outside investors, because what I am referring to is my personal investment portfolio.
What does a good hedge fund make? It makes money. Very few hedge funds achieve great returns, and if they do, they are not doing it consistently. More than 50% are showing losses, and many others are earning returns in the low single digits. Even those numbers may not be trustworthy. Lack of reporting controls tempt hedge fund mangers to inflate performance.
Benjamin Graham encouraged value investing. He didn't encourage chasing bubbles; he wasn't impressed by puffery; he viewed wealth building as playing the long game. It is a good idea if you plan to live beyond next quarter's financial statement. Hedge fund investors should expect nothing less from a hedge fund than from any other well-managed company.
If Benjamin Graham were alive today, he would probably encourage you to determine whether or not hedge fund managers have any prior experience running a business. It is a fair question, given their high expectations of compensation. Do they know how to control costs, including management compensation, office space, computer maintenance, disaster recovery, phone systems, reporting systems, accounting, compliance, data, research and development, trading systems, and support staff? Have they ever dealt with the distractions of managing an office while managing a portfolio? Do they have a long solid track record? Usually the answer is no.
I am in favor of a more Graham-like approach. Focus on value. How experienced is the management? Can they make a reliable product, and produce it at a low enough cost to provide value to the investors? Do they provide a consistently good return on capital? Evaluating the performance of hedge fund managers should be no different than analyzing the performance of any other money-making enterprise.
Part One of "My Favorite Hedge Fund" appeared previously.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting and expert-witness services. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business, and she has authored a pair of books on the credit markets that are the global bestsellers in their respective fields:
Credit Derivatives & Synthetic Structures (John Wiley & Sons, 2nd edition, 2001) and Collateralized Debt Obligations & Structured Finance (John Wiley & Sons, 2003).
First Published in the Yearbook and later in LIPPER HedgeWorld October 24, 2005
By Janet Tavakoli
Desperate times call for desperate measures. Teetering on the brink of bankruptcy qualifies as one of those times. Although the ownership partners of Long Term Capital Management acted as fiduciaries for outside fund investors, they borrowed US$38 million from the fund to pay the salaries of their own employees. It was contractually allowable, at least according to Roger Lowenstein's book When Genius Failed. The partners worried that if they didn't pay employees, they would quickly lose them, and they were probably right.
Hedge fund investors include high-net-worth (mere multimillionaire) and ultra-high-net-worth (more than US$30 million) individuals. The problem is that many managers and employees of smaller hedge funds are not as wealthy as the investors, but they aspire to the high altitudes of their customers. After all, they reason, if they are taking the risk of working for a hedge fund, they should get paid for it.
How much should hedge fund employees get paid? Senior risk managers at investment banks get paid in the high six figures. A well-known bank just hired a second-tier compliance officer for $800 thousand per year. Structured credit researchers get paid anywhere from the high six figures to $1.3 million per year. A mediocre senior investment banker will earn around $2 million per year, and a good one can earn much more. But many beginning hedge fund managers—much less the rank and file employees—can only aspire to this compensation.
Yet hedge fund managers have faith that they will reach the big leagues. Institutional Investor's Alpha magazine (as quoted in the June 5 New York Times Sunday Magazine) reported that the average pay for the top 25 hedge fund managers in 2004 was $251 million. But that is for the top 25 mangers in a field of 8,000—800 of which will fail, while many others will barely scrape by this year.
Smaller hedge funds often rely on their prime brokers for risk management and trade ideas. Even so, they tend to drastically underestimate the cost of doing business. Fortunately for hedge fund managers, the fees they charge can add up faster than the miscellaneous charges on a cell phone bill. Nominal fees commonly include 2% of portfolio value and 20% of the upside. But hidden fees can be rolled in as administrative costs and hidden commission payments to investment banks. If the hedge fund documents allow loans to management, the moral hazard compounds.
Some organizations charge fees to vet hedge funds for high net worth individuals, but if you are a regular reader of hedge fund news, you probably realize that outside experts may not have better opinions or better information than you can glean on your own.
Who can you trust when it comes to your own money? No one. That means you have to be prepared to ask better questions.
TAVAKOLI'S LAW: IF SOME HEDGE FUNDS SOAR, SOME MUST CRASH AND BURN
You cannot be more diversified than the market portfolio. If you go long and short market assets, the mix does not become more diversified. Hedge funds have not created new asset classes. They simply trade in global market assets.
The stock market offers a simple way to look at this. Together, passive and active investors own 100% of the global stock market. The average return of all passive and active investors together is exactly equal to the average return of the global market. The average return of passive investors, the indexers, is also equal to the average return of the global stock market.
This means that active investing is a zero-sum game. Given that passive investors' return is the average, active investors must also have the same average return as the global market, before fees, before expenses, and before taxes. If some hedge funds wildly outperform the market, as some of the largest claim to do, other hedge funds must spectacularly underperform. Fees, expenses, and taxes just make the spectacular underperformance even worse.
I am treating individual active investors as if they were individual hedge funds and as if their average returns were at least as good as the average returns of hedge funds. I do not buy the argument that on average individual active investors under perform hedge funds. It is even possible that individual active investors outperform hedge funds after one adjusts for creation bias, survivorship bias, fraud, other misleading methods of reporting returns, and high fees.
The already large flow of money into hedge funds is accelerating. Some estimates claim that funds under management have tripled to almost $1 trillion since 2003. The overcrowding is making most hedge fund strategies look very unattractive. Many hedge funds are merely shorting (selling) volatility to earn risk premiums—selling options in a low implied volatility environment and selling credit default protection in a skinny credit spread environment—trying to hedge away the fat tails of risk. Underperforming hedge funds resort to leverage in a gamble to inflate returns.
CREATIONISM VERSUS EVOLUTION
The barriers to entry into the hedge fund world are low, and there seems to be a philosophy in the hedgosphere that "anyone can do it." It seems all it takes to go from zero to hero is swagger and loudly trumpeted claims.
Much is made of the distortion in hedge fund indexes due to survivorship bias, the fact that failed funds drop out of the equation. Creation bias is probably a larger problem. Only "successful" funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial out-performance has a halo effect on later years, since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre.
Rapid growth can be a problem for the new creations. As money flows in, the funds often cannot replicate out-performance and devolve into underperformers. If one uses weighted average returns—weighted for funds under management—the picture is dismal.
BENJAMIN GRAHAM'S HEDGE FUND
My favorite hedge fund is still my own. Benjamin Graham, author of Securities Analysis and The Intelligent Investor, was the most influential investment adviser of the 20th century. I like to think that Benjamin Graham's favorite hedge fund would look something like mine. The after-tax returns beat most hedge funds. I trust the management and keep the overhead low. I have no outside investors, because what I am referring to is my personal investment portfolio.
What does a good hedge fund make? It makes money. Very few hedge funds achieve great returns, and if they do, they are not doing it consistently. More than 50% are showing losses, and many others are earning returns in the low single digits. Even those numbers may not be trustworthy. Lack of reporting controls tempt hedge fund mangers to inflate performance.
Benjamin Graham encouraged value investing. He didn't encourage chasing bubbles; he wasn't impressed by puffery; he viewed wealth building as playing the long game. It is a good idea if you plan to live beyond next quarter's financial statement. Hedge fund investors should expect nothing less from a hedge fund than from any other well-managed company.
If Benjamin Graham were alive today, he would probably encourage you to determine whether or not hedge fund managers have any prior experience running a business. It is a fair question, given their high expectations of compensation. Do they know how to control costs, including management compensation, office space, computer maintenance, disaster recovery, phone systems, reporting systems, accounting, compliance, data, research and development, trading systems, and support staff? Have they ever dealt with the distractions of managing an office while managing a portfolio? Do they have a long solid track record? Usually the answer is no.
I am in favor of a more Graham-like approach. Focus on value. How experienced is the management? Can they make a reliable product, and produce it at a low enough cost to provide value to the investors? Do they provide a consistently good return on capital? Evaluating the performance of hedge fund managers should be no different than analyzing the performance of any other money-making enterprise.
Part One of "My Favorite Hedge Fund" appeared previously.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting and expert-witness services. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business, and she has authored a pair of books on the credit markets that are the global bestsellers in their respective fields:
Credit Derivatives & Synthetic Structures (John Wiley & Sons, 2nd edition, 2001) and Collateralized Debt Obligations & Structured Finance (John Wiley & Sons, 2003).
First Published in the Yearbook and later in LIPPER HedgeWorld October 24, 2005
Janet Tavakoli
President
Tavakoli Structured Finance, Inc.
Chicago, IL
312-540-0243
First Url: Tavakoli Structured Finance, Inc.
Second Url: Credit Derivatives & Synthetic Structures
