Full disclosure. I run a hedge fund. I am not evil, and I do think I offer value for my investors. I will admit that there are many in the alternative investment universe that are just an embarrassment.
Much of the commentary I see around hedge funds these days includes the need for greater regulation, lower fees, and smaller funds. Often in the same breadth. This will not end well. Regulation is expensive, and with lower fees and less funds under management, something will have to give. Maybe the fund under staffs on execution, or administration, or research, but the management fees that a fund accrues is a limited and shrinking pie. If you increase the size of the slice going to regulation, less will go to other areas. And that will have an impact.
Also, I really don’t think you can honestly be sure that the hedge fund industry in particular, or the financial services industry in general needs more and new rules. What does need to happen is more vigorous application of the rules already on the books, and the enforcement agencies need both more and better staff.
For example, take a stretch of highway where there are a lot of accidents and lots of speeders, but no traffic cops enforcing the speed limit. Does this stretch of highway need new rules requiring the use of helmets and 3 point seatbelts to reduce highway fatalities or should we first try enforcing the speed limit? First put a bunch of police who are knowledgeable about enforcing the speed limit and see what happens.
And putting new rules in place can have horrible unintended consequences. In the above example, new seat belts are expensive but the helmets reduce visibility. New regulations will create many unknowns which are likely to be very expensive to explore. Investors and managers do tend to learn from the past (sometimes they give way too much weight to the recent past), but regardless I doubt we will see the same type of mistakes that allowed Madoff to run wild, and banks to pay huge bonuses for assets still held on their books. But new rules, will create new troubles which we can’t anticipate.
Does anyone else find it ironic that the institutions that seem to have gotten into the most trouble are those that are the most heavily regulated? In reality this regulation was a lot of rules, but not a lot of knowledgeable enforcement. Being Mr. Simple Sense I would bet that fewer simpler rules might even result in better enforcement, and a safer investment environment.
But since new rules seem to be coming I will grudgingly makes a couple of suggestions (which I would rather see as best practices than rules).
1. Match up investor liquidity with asset liquidity. If you invest in highly liquid instruments then provide monthly liquidity to your investors (like I do). If you invest in illiquid instruments use the private equity model of raising money for a fund, invest it and then 3-10 years down the road you liquidate it with no fund raising or redemptions allowed in between. And Fund of funds (if they survive) should also match the liquidity they provide investors with the liquidity the managers provide them—across the board.
2. Change the fee structure of hedge funds so that everyone in a fund pays the same fees and those fees are adjusted as the AUM change. Specifically management fees start high (like 2%), and performance fees are a bit lower (like 15%) and as the AUM grows the management fee everyone pays goes down and the performance fee goes up. This will allow smaller or newer managers to generate enough management fees to properly resource their business, and will encourage larger managers to focus more on performance and less on growing and retaining assets. Since newer-smaller managers know performance will drive AUM growth, the lower performance fee at the start should not prove to be a disincentive. This should help to optimize fund AUM for both investors and managers.
Please post your comments (esp. on the fee structure—I am dying to hear your thoughts).
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2 comments:
Regarding the fee structure, in addition to locking up the funds equivalent to the liquidity of the investment style, payment of incentive fees should follow a similar duration. If the investment is locked for 3 years, a one-year incentive fee structure could lead to payment of significant incentive fees in year one and two and still result in a loss to the investor if year 3 is a disaster. Investors should demand that the incentives are aligned and incentive fees are earned at the time the money is available for withdrawal.
Actively managed mutual funds have only recently seen downward pressure on their fee structures. These vehicles have an aggregate history of underperforming their benchmarks and being far less tax efficient than their index oriented peers, however they have earned excessive rates of return not for their investment prowess but for their asset gathering capabilities.
The key in my view is aligning fee structures with promised investment proposition. In that way both managers and investors are driven toward the same goals and fees are paid based on the attainment of those results.
couldn't agree more
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