50 Trades Of Grey

Last week I went with my wife to see “Fifty Shades of Grey”, the latest box-office hit about a college graduate, Anastasia, and her relationship with billionaire CEO Christian Grey. Grey attempts to cajole her into signing a contract that formalizes her role as a “submissive” in the relationship. It’s probably not what the director intended, but the film got me thinking about the kind of contracts that investors sign when they hand their money to hedge funds (it was a long film, okay…).  Here is how most of these contracts go:

The Client and the Manager agree and acknowledge that all that occurs under the terms of this contract will be consensual, confidential, and subject to the agreed limits and safety procedures set out in this contract

The Client will maintain a quiet and respectful bearing in the presence of the Manager.

The Manager may trade excessively, adopt highly leveraged positions and engage in esoteric bets as he sees fit, for his own personal enjoyment, or for any other reason, which he is not obliged to provide.

The Client consents to paying away 2% of the fund each and every year, regardless of how the fund performs.

The Client consents to paying away 20% of profits earned, regardless of whether these profits were earned as a result of market moves or the Manager’s skill.

The Client will accept chronic underperformance, redemption penalties, lock-ins and excessive fees without hesitation, enquiry or complaint.

The safeword “redemption” will be used to bring to the attention of the Manager that the Client cannot tolerate any further fees. When this word is said the Manager will wind up what’s left of the fund, take his fees and relocate to the Cayman Islands.

The client is getting a pretty raw deal here. Like poor Anastasia you might be inclined to ask “What’s in it for me?” When you sit down and work through the fee structure of a hedge fund, you realize just how one-sided it really is. Performance fees are the worst type of fees, because they only apply one way: You pay these fees when the fund performs but you don’t get them paid back to you when the fund underperforms. It’s the old heads I win, tails you lose bet.  Many funds have a “High Watermark” which means that if the fund underperforms, it won’t collect performance fees until it returns to the previous high.  This is all well and good, but it assumes that the manager will deliver on the mandate over the long haul. It’s not much comfort when the funds are underperforming and you have no realistic prospect of ever getting back to that previous high.

Imagine now that you are asked to go to a casino with $1000 of someone else’s money. You’re told you’ll keep a proportion of any winnings, but any loss of capital is borne by the client. And, at the end of the night you’ll get $20 for your trouble regardless of the outcome. Oh, and the drinks tab will be picked up by the client too! The rational thing to do is go hell for leather – take aggressive bets until you win big or go broke. This is exactly the position that we put the hedge fund manager in when we pay them one-sided “performance fees”.

A simple back of the envelope calculation shows how much of the client’s capital can be eaten up by fees over a 10 year market cycle. This example assumes that the underlying fund performs in line with the market, and adopts a “2 and 20 structure” with a 4% hurdle rate (i.e. performance fees only apply after a hurdle of +4% is attained).

The result is quite shocking. After 10 years, the index is up by 20%, while the hedge fund, whose underlying performance was exactly the same as the index, is down by 5%.

You might say the very purpose of hedge funds is that they are independent of market direction. However, when you’re 6 years into a bull market, there is strong pressure on hedge funds to adopt strategies that look suspiciously like a long-only benchmark-relative fund. These managers make out with huge performance fees during bull market years simply by riding market direction. By the time clients work out what’s going on, these managers have already extracted (sorry…earned) considerable performance fees.

Funds of hedge funds are even worse, since you’re layering on 2 levels of fees. Back in 2008 Buffett made a $1m bet with Protégé Partners, which was as follows:

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

7 years into the bet and  Buffett is comfortably ahead.  The S&P is beating the fund of hedge funds quite handsomely, with the index fund up 63.5%, versus the fund of hedge funds up only 19.6%. While underlying, the hedge funds might have performed close to the index, seven years and two layers of fees have done their job of eating away at the capital.

It’s no wonder that hedge funds are starting to lose their allure. Last year the California Public Employees’ Retirement System (CalPERS), the largest pension fund in the US, decided to exit entirely from its $4bn investment in hedge funds, citing the high cost and poor performance.

There are still 2 films to go in the “Fifty Shades of Grey” series. I haven’t read ahead, but I suspect that Christian Grey will come to love Anastasia, and the contract will fall by the wayside. Unfortunately in the hedge fund world, it’s unlikely that we’ll have the same happy ending. I can’t see a hedge fund manager arriving at an epiphany where they tear up the contract and decide to do what’s best for the client. Until clients stop signing these contracts, fund managers will continue screwing investors with impunity!