When Institutional Investor's Alpha magazine released its annual list of the highest paid hedge fund managers last month, it allowed the rest of us to play an entertaining little parlour game: What could you buy if you made as much money as those guys?
James Simons, a 69-year-old mathematician who was at the top of the list, made $1.7 billion (Rs6,970 crore), which equals the amount of money that the federal government spent last year running its vast network of national parks. Down at No. 3 on the list, Edward Lampert, the Greenwich, Conn., investor who owns a large chunk of Sears, earned $1.3 billion, which, if you forget about taxes, would have allowed him to purchase the entire economic output of Sierra Leone. We're talking about real money here.
On Wednesday, Alpha magazine will release the second of the two big lists it puts together each year, and this one offers a chance to answer another, arguably more important, question: Are these billionaire hedge fund managers really worth it?
The reason hedge funds are a licence to print money is their fee structure. A typical fund charges a 2% management fee, which means that it keeps 2 cents of every dollar that it manages, regardless of performance. Mutual funds, on average, charge about 1%.
On top of the management fee, hedge funds also take a big cut—usually at least 20%—of any profits that exceed a pre-determined benchmark. So in a good year, a fund brings in stunning amounts of money, and in a bad year, their managers still do very well.
Alpha male: At $1.7 billion, James Simons’ earnings equal the amount the US spent last year on running its vast network of national parks.
The new Alpha list ranks the 100 largest hedge fund firms in the world; to make the list, a firm needs to be managing almost $5 billion. Some quick math shows why it's such a good business: 2% of $5 billion equals $100 million, and a fund's managers get to take that cut every single year.
Last year was actually a pretty tough year for hedge funds. The original idea of a hedge fund was to earn a profit even when the stock market was falling, by making a fair number of countercyclical bets. Of course, this also means it's harder to keep up with a broadly rising market. Last year, the Standard & Poor's 500-stock index jumped 14%, while the average hedge fund returned almost 13%, after investment fees, according to Hedge Fund Research in Chicago.
But the men—and they are all men—who appear on Alpha's list of top earners do not manage average hedge funds. They manage the biggest funds in the world, the ones that are winning the Darwinian competition for capital, and many of them aren't having any trouble beating the market.
One of the funds at Simons' firm, Renaissance Technologies, delivered a net return of 21% last year. The other returned 44% after fees. And Simons, who relies on a fantastically complex set of algorithms, does not charge "2 and 20"—as the typical industry fees are called. He charges "5 and 44"—a 5% management fee and 44% of his profits—yet he has still been doing very well by his investors for almost two decades now.
A lot of people find nine- and ten-figure incomes to be inherently excessive. Or even immoral.
From a strictly economic point of view, however, they are also perfectly rational. You cannot find anyone else who is providing the same returns as the best hedge fund managers at a lower price. If you don't like it, you don't have to give them your money. (Even if you do like it, they probably won't take your money. In exchange for being lightly regulated, hedge funds are open only to wealthy investors and big institutions.)
Thanks to their incredible performance, the biggest funds have grown far bigger in recent years. The 100 largest firms in the world managed $1 trillion at the end of last year, or 69% of all the assets in hedge funds, according to Alpha. At the end of 2003, the top 100 had less than $500 billion, or only 54% of total hedge fund investments.
"The best performance is coming from the largest funds," said Christy Wood, who oversees equities investments for the California Public Employees' Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.
But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years will not be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it harder for fund managers to find truly undervalued investments. The world is awash in capital.
All that capital, of course, also translates into ever-greater management fees, regardless of a fund's performance. The flagship hedge fund at Goldman Sachs lost 6% last year, but it still brought in a nice stream of fees. Bridgewater Associates, which is based in Greenwich, has earned a net return of less than 4% in each of the last two years. Yet, its founder, Raymond Dalio, still made $350 million in 2006.
"When we have a bad year, we're essentially flat," Parag Shah, a Bridgewater executive, said. "And when we have a good year, we have a great year."
Goldman and Bridgewater may well bounce back, but the combination of extraordinary pay and ordinary performance is going to occur more and more in the coming years. Outside of the high-fliers on the Alpha list, it's already the norm. Since 2000, the average hedge fund has not done any better, after fees, than the market as a whole, according to research by David Hsieh at Duke. Yet even mediocre managers, after a lucky year or two, are able to attract gobs of capital and charge "2 and 20."
So are today's hedge fund managers really worth it? Sure, but only if they deliver the sort of performance that Simons has, and very few will in the years ahead. More to the point, it's extremely difficult to know in advance who the stars will be.
In all sorts of walks of life, people tend to think that the past is a better predictor of the future than it really is. It's why so many investors chase returns.
The genius of the world's hedge fund managers isn't only in how they investtheir money. It also lies in having set up an industry that takes advantage of a timeless human trait.