Mutual Fund Managers = Minor Leagues

I have always been sort of fascinated by the shady world of hedge funds, and I had some idea of what they were, but I wasn’t clear on a lot of things. Lately I have been doing some reading on the topic (starting with The Little Book of Hedge Funds and then looking into a few of the author’s suggestions from there). A couple things I know for sure after reading thoughts and opinions from vaunted “industry insiders” is that:

1) I am not cut out for hedge fund investing, and I wouldn’t have enough money to invest in them for at least a decade even if I decided they were for me.

2) The relatively few people on the planet that can “beat the street” are almost assuredly in the hedge fund world (re: NOT mutual funds).

For those of you that don’t know much about hedge funds, I definitely won’t hold myself up as an authority on the topic, but the basic idea is a pool of capital that is exclusive to wealthy investors, and has very few rules and regulations as to what can be done with the capital at its disposal. Without throwing around too many overly technical terms and Greek letters, the theory behind the original hedge funds was that these pools of money would be able to “hedge” against their investments, or protect their downsides. This is different from the world of mutual funds where money managers are basically only allowed to “go long” and invest in stocks they believe will increase in value. Although those are the origins of hedge funds, the modern day versions span a huge range of structures and investment classes. The overall premise behind today’s hedge funds is that they can invest almost any way that they want with almost no oversight. If managers want to throw everything into derivatives they can, if they want to go to cash, or short European markets, they can do that too. The freedom that these money managers have is unparalleled in the industry.

“2 and 20”

hedge fundsIf hedge fund managers are able to parlay this freedom into above-average returns (as a substantial number are) they get paid quite well. The industry standard has apparently been coined as, “2 and 20”. The numbers stand for 2% of assets up front, and 20% of profits generated. If that seems extreme, that’s because it is. Warren Buffett is actually on record as saying that due to this compensation model he is dubious of the whole idea that investors can make money in hedge funds over the long-term. Of course the old Oracle himself did run hedge funds early in his career, and now employs former hedge fund people as some of his top advisors, so you figure it out. The reality is that hedge fund managers make incredible amounts of money. If they have a modest-sized fund of $100 million, they would automatically make $2 million in a given year. If they matched the market in an average year and their portfolio rose 10%, they would take home 20% of the $10 million profit ($2 million). That’s for a fairly small hedge fund.

The Cream Rises To The Top

When I go through my usual sparring matches with mutual-fund devotees, one of the things I like to point out is that John Bogle (founder of Vanguard) and several large-scale studies have proven beyond a shadow of a doubt that mutual fund investing will almost never beat index funds, and that it is extraordinarily difficult (some say impossible) to pick a mutual fund ahead of time that will beat the market. Another constant of these studies is that fewer and fewer mutual funds are actually beating the market relative to the rates of yesteryear. One common assertion is that the quickly-growing hedge fund industry has poached the few bright stars in the mutual fund world, leaving the scene with a bunch of “closet indexers” as Ed Rempel likes to say. Given what I have learned about the compensation levels in the hedge fund world, and the freedom those investment managers have, I am quite certain this is the case.

Why I’m a Bad Canadian

I grew up in southern Manitoba near the USA border. I loved football as a kid and I still do today. When I was young, I like watching CFL football because it fun, it was what most people around me watched, and I wanted to fit in and cheer for the home team (the beleaguered Winnipeg Blue Bombers). As I got older I started to watch more and more NFL games, and now that is what I watch almost exclusively. It’s not that I’m a turncoat non-patriot, it’s simply that one is a minor league, and the other has some of the best athletes in the world. One league pays pretty well for playing a kids game, the other league makes you rich even at a league minimum contract. It doesn’t take a genius to figure out where the talent will flow to. Don’t get me wrong, there are still some really good athletes in the CFL, and occasionally a real diamond pops up – and they are promptly scooped up by the big boys the next season.

“Show Me The Money!”

Much like the CFL, I’m sure there are few stars that come out of the mutual fund farm team. The question is, why would they stick around when there are bigger pay days and brighter lights in the big leagues? Logic says that if there are thousands of hedge funds that pay top dollar and have immeasurably more maneuverability than mutual funds, this is likely a large part of the reason why the majority of mutual funds underperform their benchmark yearly, and why virtually all of them underperform over the long-term after fees are calculated in.

Even after reading about the extraordinary returns that some hedge fund managers are able to produce, I am not at all confident in my ability to pick those managers out, or in my ability to stomach the risks that many routinely take (even though they were ironically created to hedge against risk). I’ll stick to my passive ETF investing strategy and gladly take the average as the big boys duke it out at the top and suck up billions of dollars of investors’ money in the process.

This post was featured in the Wealth Management Carnival, Investment Edition

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14 Responses to Mutual Fund Managers = Minor Leagues

  1. Hi Teacher Man,

    I think that you should’ve mentioned some hedge fund manager has hurdle rates and high water marks. Hurdle rates are minimum accept accetable rates of return and high water marks are performance fee policies that specify that the fund manager will only be paid a percentage of the profits if the net value of the fund exceeds the previous highest value achieved by the fund. I think if any fund manager has both of them without any maintenance fee, I am willing to give him 40% of gains (above the hurdle rates). but not sure if anyone does that.

    • What you’re saying is definitely true John, some people do use hurdle rates, but from what I have seen (and admittedly I have not seen much) those funds still charge fairly decent upfront management fees. I admit that if they have their own skin in the game and they have some performance incentives it may work out, I just think the odds of you selecting the right one are not nearly worth the risk, especially when indexing works so well. Certainly you would have a better shot than with mutual funds, I’ll grant you that.

      • Former hedge fund analyst here.

        You should note that while high water marks are indeed prevalent, in reality, they mean jack squat. Let me explain.

        But first, for people who don’t know, a ‘high water mark’ is basically a guarantee that if a fund loses money, it has to gain it all back before it charges the hefty 20% performance fee. e.g. if the high point of the fund was $10,000/share, and it goes to $9,000, then it can’t charge performance fees until it reaches $10,000 again.

        The reason it means jack squat, is because a fund that loses significantly usually closes shop. Put yourself in the manager’s shoes – let’s say your fund goes from $10,000/share to $8,000/share. Would you be excited about making $2,000/share? No, because you don’t get to charge performance fees. Instead, they close that fund up, and start another one. That way, you reset the high water mark. Or, if you can’t do that, you take really high risks. They pretty much flip a coin – if it’s heads, they win, if it’s tails, you lose.

        Stay away from (most) hedge funds.

        • Completely agree Jin. The incentives are always to take more risk – regardless of long-term best interests. That is a systemic problem. Are you a supporter of indexing then?

          • Yes, but with a caveat. I recommend almost everyone I know to go with index funds. That’s in large part what my business is about.

            However, I’m a hypocrite when it comes to investing my own money. I won’t buy any ETFs other than bond ETFs. Why? Because I think I can get better returns picking individual stocks.

            Canadian Couch Potato, for instance, believes that the market is efficient – that you can’t actually choose winners or losers. I think this is plain wrong, and I think I can do a good job backing that up.

            However, I’ll agree that most people can’t choose winners or losers. That’s why I recommend index funds.

          • I don’t think it’s a hypocritical stance Jin. I think that at some point in my life – when I have more leisure time to look over stocks – I could start to dabble in stock picking. At this point, I can’t dedicate the necessary research time I believe is needed to outperform the market.

            I’m with Dan Bortolotti (CCP) in thinking that Efficient Market Theory is the real deal, but I will add the caveat that it works much better as a theory over the long-term. I think over the short-term the market is much less rationale/efficient – especially in small cap stocks. If you are going to be a stock-picker I think the two ways to succeed over time is to have a mastery-level expertise within a certain industry (probably bordering on insider knowledge) and/or to know your way around small-cap stocks that don’t get much media attention.

            I’m glad to hear that your advice takes into consideration the limitations for most of us investing mortals!

  2. Sounds like yet another example of how the rich get richer and the poor get poorer (or at least, no richer than everyone else). Informative post – I had no idea what the difference was between a hedge fund and mutual fund before this.

  3. Yeah the 2 and 20 rule is pretty standard, even for other types of funds in the exempt market that’s not considered hedge funds or mutual funds. It takes a lot of confidence as investors to believe that someone can have that much alpha, but apparently this type of market exists for a reason I guess :0) I didn’t know the dummies book series had one on hedge funds, good stuff, haha.

    • Not the dummies book series, but the “Little Book” series. It’s actually really really good, I highly recommend the whole series. I think there are probably people out there than can absolutely smoke the market (otherwise how do so many massive-sized mutual funds lose?), but I a dubious as to how long they can do it for, if I can identify them ahead of time, and most of all – if I even have access to them!

  4. I once read a book called Hedgehogging. The world of hedge fund managers, and managers of “funds of funds” is a fascinating one, and way far removed (at least in terms of money and affluence) from the comparatively humble one of regular fund managers.

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