Hedge funds are legal?

April 13, 2009 1:35 PM

Just what exactly is it that hedge fund managers do that warrants the exhorbitantly huge amounts of money (IMHO) they apparently make?

Assume I know nothing about financial markets and investing (not far from the truth, as it happens) in formulating your answer, please. Also, if you use the phrase "creating wealth" or something like it, know that I will have to track you down and punish you.

posted by qurlyjoe to work & money (32 comments total)

The fact that people are willing to pay them. Basically, hedge fund managers make profit each year based on how much their clients portfolios increase. So if you give a hedge fund manager $100, and and the end of the year you have $120, you give him X% of $120-$100= $20.

So if you have an agreement that he gets $20 of the profit, then you pay him $5.

The problem, of course, is that the hedge fund manager gets paid each year, and your portfolio could crater taking all your wealth with it.

But, for people who didn't believe that an economic catastrophe was coming, it actually wouldn't make sense not to pay these fees.

But more simply, hedge fund managers made what people thought they were worth. (they were probably wrong, however)
posted by delmoi at 1:40 PM on April 13 [2 favorites]

They manage funds that make even more exorbitantly huge amounts of money: according to this article from 2008, "New York City hedge funds earned $20 billion to $39 billion last year".

So, is your question why hedge fund managers make so much, or is it really why hedge funds themselves make so much?
posted by inigo2 at 1:40 PM on April 13

They're not actually all that exotic if you don't care about the details of investment; basically, hedge funds are a particular flavor of extremely high-risk investment. If you take a lot of risk, you have the potential to make a lot of money; in theory it therefore makes sense to offer really huge cash incentives so as to get the best possible people to do it, since the high compensation is exceeded by the potentially-massive profits they generate for the people whose money they use.
posted by Tomorrowful at 1:40 PM on April 13

Hedgefund managers make rich people richer and are compensated with a portion of those riches.
posted by blue_beetle at 1:43 PM on April 13

Inspector, I picked the title because mefi made me pick something, so the title was a tad tongue-in-cheek, my question, however, is serious.
posted by qurlyjoe at 1:45 PM on April 13

Hedge funds are allowed to take additional risks because there is not any significant regulation of them.

This means that you want someone who can understand all of those risks. Whether they do understand them is another story, but it seems like at least some investors find the fees worth it (or they wouldn't fork over their money)
posted by Pants! at 1:48 PM on April 13

I can see by the answers so far that I was not clear what I was asking. I'll try again.

I understand that what they do is risky, and that high risk is somehow equated with high return.

What I don't understand is what the word, "manage", involves. Are we just talking about picking the right investments at the right time? Is it really as simple as that.
posted by qurlyjoe at 1:49 PM on April 13

What I don't understand is what the word, "manage", involves. Are we just talking about picking the right investments at the right time? Is it really as simple as that.

Basically.
posted by delmoi at 1:50 PM on April 13

Because they can. If you want to invest in a hedge fund with a lower management fee, by all means do so. Fees, however, are a means of quality signaling in a market where the consumers really have very little to go by in terms of differentiating the quality of the products (hedge funds). If you were a bank with a billion dollars to put into a hedge fund, would you want to go with the cheapest manager on the market?
posted by GuyZero at 1:53 PM on April 13

How to get rich as explained by my high school economics teacher who lost 4 fingers in Vietnam before going to Harvard:

Figure out where large amounts of money is changing hands, then get in the middle somehow and take a little for yourself.

These guys have positioned themselves according to the advice given above.
posted by mds35 at 1:55 PM on April 13 [2 favorites]

"is" is Harvard speak for "are."
posted by mds35 at 1:56 PM on April 13

Are we just talking about picking the right investments at the right time? Is it really as simple as that.

So, uh, got any hot stock tips?
posted by phrontist at 1:58 PM on April 13

Are we just talking about picking the right investments at the right time? Is it really as simple as that.

And being a doctor is as simple as writing prescriptions for medicine. ;-)

OK, not to be snarky, but yes, you could boil the job description down that way. But this really is one of those cases where you can say, "if it were easy, everyone would do it." If you fail at investing correctly, then your clients take their money somewhere else, and then you're not able to charge fees and collect commissions. The guys that are better at it can charge more for their services.
posted by Cool Papa Bell at 1:58 PM on April 13 [1 favorite]

Well if you do a little digging you will see that the days of 2 and 20 are gone, probably forever. There is no government restriction on what you charge people for services rendered. HF managers convinced people for a long-time that they were just smarter then everyone else. Turns out they weren't (for the most part) and you can replicate what they do at a fraction of the fees.

Yes - what a hedge fund manager does is take your money and invest it. Hedge funds have no legal limit on what they can invest in. Hedge funds generally mark their performance daily (as opposed to private equity funds) and take a base fee for managing your money + a portion of the profits he has has made for you.

Because they can. If you want to invest in a hedge fund with a lower management fee, by all means do so. Fees, however, are a means of quality signaling in a market where the consumers really have very little to go by in terms of differentiating the quality of the products (hedge funds). If you were a bank with a billion dollars to put into a hedge fund, would you want to go with the cheapest manager on the market?


I have some very very smart friends who are very successful at managing money. When they struck out on their own in 2004 they originally offered lower fees. They had some reasons why they thought the lower fees were reasonable (they weren't promising low volatility of returns, they wanted 5 year lock ups of the capital, etc) The first few pitches they had went well until they got to the price conversation. It was only once they priced at something closer to industry standards that they got money outside of the channels they already had relationships in.

Any judgment on the value of HF's and their fees can't be made for at least another 20 years. I'm pretty confident we will see the vast majority of them we not worth the higher fees.
posted by JPD at 2:05 PM on April 13

You don't seem to be getting very concrete answers so I will do you the favor of cutting and pasting the Wikipedia entry on hedge funds, which explains it pretty clearly:

A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds and pays a performance fee to its investment manager. Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt, commodities and so forth.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy, investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the nature of the fund.

The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.

Read more there for further details.
Worth noting: the classic "hedging" techniques usually employ sophisticated mathematical models:

Systematic macro - trading is done purely mathematically, generated by software without human intervention
* Commodity Trading Advisors (CTA, Managed futures, Trading) - trading in futures (or options contracts) in commodity markets.
* Systematic diversified - trading in diversified markets.
* Systematic currency - trading in currency markets.
* Trend following - profit from long-term or short-term trends.
* Non-trend following (Counter trend) - profit from trend reversals.

posted by beagle at 2:15 PM on April 13

What I don't understand is what the word, "manage", involves. Are we just talking about picking the right investments at the right time? Is it really as simple as that.

Basically.

What you're leaving out of this formulation is that 2 and 20 on nothing is nothing. A huge, huge part of running a successful hedge fund is being able to attract assets. Personally, I think that's more important than actually being a good investor. There are tons of little funds here and there with pretty good performance that can barely keep the lights on (2 and 20 on 100m doing like 5-10%/yr isn't that much. Especially if the strategy is supposed to be a low-volatility, consistent-returns strategy.) You could make the argument that like, exemplary performance over a really long time (SAC Capital, the old big fund (Medallion?) at Renaissance) will attract those huge amounts of assets, but in reality, two things keep this from being true in the general case:
1) Most hedge funds haven't been around that long.
2) Most of the really successful ones that have largely manage only the partners' money now.

A lot of these huge funds where the managers are making crazy money don't have amazing enough or long enough track records to convincingly demonstrate that they are doing anything better than any other idiot with a Bloomberg. The incentive structure is such that its way, way better to raise a huge amount of money and take a huge swing, like Paulson Credit Opportunities or Lampert's ESL. If you lose, you get a job. If you win, you are insanely rich. If you lose, you don't even get a job, you close the fund and open a new one or renegotiate with your LPs to get a lower high-water mark. Its a racket.

So anyway, if I was going to start a hedge fund, and I a genie said I had the choice of being awesome at investing and average at attracting capital or awesome at attracting capital and average at investing, I would take the latter. I think its a no-brainer. I mean look at guys like Eric Mindich and Vik Pandit. I don't know how Eton Park is doing right now, but as far as I know, it was never doing very well, but Mindich's Golden Boy rep helped them launch with over $3bn, so he's killing it. Vik Pandit, as far as I can tell, never demonstrated anything close to awesome investing ability at Old Lane, the fund barely even launched (and the launch was a disaster), but they attracted a ton of capital and then Citi bought them out so that they could make Vik Pandit CEO of their ridiculous joker bank.

Then you take a guy like say Mark McGoldrick. McGoldrick is, by all accounts, pretty freakin' stellar at investing, but its hard to factor out how much his unique situation at GS helped him (elastic balance sheet, deal flow, talent flow, etc.). Either way, despite the fact that he made ridiculous amounts of money at GS by normal person standards, he doesn't get paid nearly what these guys get paid.

I realize this is a somewhat chatfiltery answer, but this is lets say a bit of a sore spot with me. The whole industry is running in a ridiculous way right now, and its absurd compensation structure is probably destructive to the global economy. For what its worth, the existing comp regime is probably going away for most people. Even a lot of people in the business think it has to change.

Anyway, to speak to your implied angriness-point a bit though, there is some sort of economic sense in paying people who truly could manage money exceptionally well exceptionally well. If one person can effectively manage billions of dollars in way that maximizes return per unit risk over a long run, thats of insane value to the whole economy. Its one person generating a whole lot of value. That's effectively what we have a financial system for, so you if you can replace huge expensive swaths of it with one dude who does it better, sure, it makes sense to pay that guy a lot. Entrepreneurs, venture capitalists, real estate appraisers, traders, merchants, bank loan officers, I mean there are tons of of people who's draw from the economy is based on the idea that they are being paid to optimize our allocation of our limited economic resources. Unfortunately, this has roughly nothing to do with how the hedge fund industry actually works in practice.
posted by jeb at 2:18 PM on April 13 [2 favorites]

Why Aren’t Hedge-Fund Fees Dropping? from New York Magazine, in 2007!

To quote:

Quality is a major concern; no discounted fee will ever be deep enough to compensate for the cost of investing money with an incompetent manager. (Heart surgeons don’t tend to compete on price, either.) A hedge-fund manager who cuts his fee is signaling that he can’t persuade other investors to trust him.

posted by GuyZero at 2:19 PM on April 13

Sure - but the largest group of Hedge funds has always been long-short equity - who's risk management consists of being short individual names and probably having a quick trigger on names that aren't working.

There are very few guys on that list of "highest paid" that run true market neutral funds. Frankly you just can't generate the returns they do without taking market risk in some form.
posted by JPD at 2:22 PM on April 13

The guys that are better at it can charge more for their services.

This is exactly what I'm talking about: there is precious little evidence that this is true. Some of this is because hedge fund people successfully played the branding game, I think. For high-net worths (not the biggest source of funding anymore but it certainly was) being in the right fund was like being in Sequoia in the 90s. Its a source of social cachet. So basically the guys who charge more can charge more. Like with Louis Vuitton bags. Or Bernie Madoff. In economics terms, for a few years, hedge funds became a type of a Veblen good.
posted by jeb at 2:22 PM on April 13

Worth noting: the classic "hedging" techniques usually employ sophisticated mathematical models:

True, but very, very few hedge funds actually do this in practice. The overwhelming majority of hedge funds are run like mutual funds with leverage and shorting.
posted by jeb at 2:23 PM on April 13

Notice the date on that article.
posted by JPD at 2:23 PM on April 13

Dude you stole my line
posted by JPD at 2:25 PM on April 13

OK, not to be snarky, but yes, you could boil the job description down that way. But this really is one of those cases where you can say, "if it were easy, everyone would do it."

I disagree. To make an art-world analogy, I really could hire a bunch of assistants to paint a bunch of colored circles in a grid on a canvas. But no one would pay me Damien Hirst-like prices for those canvases. There's a complex confluence of cultural forces (alliterate much?) that make people pay Damien Hirst those prices, and similarly, there's a slew of reasons why most joker hedge funds are able to attract the necessary few hundred million that make it worth turning the lights on, but as with Hirst and hiring people to paint the circles, the difference is not ability to pick investments.
posted by jeb at 2:32 PM on April 13

What others said about the basic equation: taking a small percentage of "metric shitloads of money" still equals "a shitload of money".

The other point is that there's a tacit understanding that the hedge fund manager has lots of skin in the game, and his/her own investment money is part of the fund. In essence, hedge funds are really just a scaled-up version of writing a check to a friend and saying "make me some money, just spare me the gory details."

As JPD says, there are all sorts of psychological influences at work, making investment in a hedge fund something of a Veblen good, versus regulated mutual funds or index funds. (Madoff's Ponzi scheme was explicitly based and sustained upon an appeal to status.)

This isn't to say that hedge funds aren't competing for investment capital, but it's more like the way haute couture houses compete on the catwalk than, say, how H&M competes with Gap for the market in $20 pants.
posted by holgate at 2:41 PM on April 13

On shoulda-previewed: JPD got there first, but jeb's analogy to the odd ways in which the "market" prices high culture -- fashion, modern art, etc. -- is on the mark.
posted by holgate at 2:48 PM on April 13

I disagree.

Then it looks like you should go into a new line of work.

Just remember to wave to me as your yacht pulls away from the dock.
posted by Cool Papa Bell at 3:04 PM on April 13

Time will tell about hedge fund performance, but one of the under-celebrated stories of 2008 was that hedge funds, as a whole, beat the pants off the broader market. A typical diversified hedge fund investor would have lost about 20% of his money, versus (for example) 40% losses in vanilla equity-heavy mutual funds.

And in defense of hedge fund managers versus artists, Damien Hirst can perpetuate his gallery price line for many years on social connnections, hype and/or subjective taste of a minority of people. By contrast, all of the connections and pedigree in the world will only keep a hedge fund manager going to the expiration of his first lock-up. After that price, it's performance that matters. This was no less true in the boom as it was now.

Also, while the Eton Park / Old Lane style high 9s / low 10s launch by a top bulge bracket executive was trendy for the last couple of boom years, by far the more common model for what are now the biggest hedge funds was to be launched with a tiny amount of assets by a then-young and fairly obscure trader, who built up returns (and attracted assets) over many years of patient effort.
posted by MattD at 3:17 PM on April 13

Some of this is because hedge fund people successfully played the branding game, I think.

Agreed. Hedge fund managers remind me somewhat of real estate professionals who specialize only in multi-million dollar properties. There's really nothing differentiating them from their lower-paid peers, but they've chosen and successfully attracted a wealthy clientele.

one of the under-celebrated stories of 2008 was that hedge funds, as a whole, beat the pants off the broader market.

The broader market can't short stocks, so in a losing year everyone should beat it -- it's a one-way street. But you're right, some of those guys EARN that money.
posted by coolguymichael at 3:27 PM on April 13

by far the more common model for what are now the biggest hedge funds was to be launched with a tiny amount of assets by a then-young and fairly obscure trader, who built up returns (and attracted assets) over many years of patient effort.

For the record, I'm not trying to argue that _no one_ in the business adds value, just that the industry is a lot less meritocratic than it (and many of the commenters in this thread) like to say it is.
posted by jeb at 3:41 PM on April 13

one of the under-celebrated stories of 2008 was that hedge funds, as a whole, beat the pants off the broader market
Fair point. But over time the fees gobble up so much of that outperformance its staggering. I mean think about it a HF reporting an up 20% year ends up only 13.8%, up 10% = up 5.9%. So if you didn't perform fantastically when times were good a HF that was down only 20% might have actually broken even with am S&P index fund over a multi-year time period.
posted by JPD at 3:50 PM on April 13

I certainly agree that the long-term relative performance of hedge funds in their contemporary form remains an open question.

However, when it comes to meritocracy, I must say that in ten years of working with (but admittedly never at) hedge funds, they're just about as meritocratic as any professional workplace I've ever seen. (Whether it compares to the meritocracy of competitive professional workplaces I haven't seen, like maybe the officer corps in the military, I wouldn't be able to say.)

At the basic level, a hedge fund lives and dies on the judgment of its limited partners, and limited partners do a terrific job of ignoring everything but after-fee performance. Sure they have to take a flier when it comes to start-ups, and did evince a weakness for a certain celebrity in the the last few years, but by and large that's a heck of a lot more meritocracy than informs most client - professional relationships.

When it comes to staffing, hedge funds take to the next level the sell-side trading floor's (relative) lack of genuflection to top school credentials versus the absolute reverence for the same in the investment banking suite, white-shoe law firm or tier one consultancy. There's a similarly minimized correlation between success at hedge funds and sociability in either its personal form of popularity or good looks, or its alternate form of good choice of parents. Their small size in all but the most extreme cases also works to minimize returns to corporate politicking.
posted by MattD at 4:05 PM on April 13

Read Jim Cramer's book "Confessions of a street addict". Very good info in there about his time as a hedge fund manager.

Basically- it's easy to seem good when the market is up. The trick is to be good when the market is down. That's how you keep your investors happy.

A hedge fund is the same thing as a mutual fund, but with different rules. It's called a hedge fund because that's what the investors are using it as- hedges against their "main" portfolio. They take a chunk of money that they can afford to lose, and hope to use it to make a shitload of money. The manager is just like a manager of any other investment fund- they try to make money by out-thinking the other guys. Except a hedge fund has more freedom to invest in leveraged investments.
posted by gjc at 6:07 PM on April 13