Their performance has been disappointing lately and they are too expensive but, at least, their managers’ interests are perfectly aligned with ours. This is a widely held view on hedge funds. But in fact, two of the three statements are false. The only one that is correct is that they are too expensive. I will discuss the disappointing performance in an upcoming post. Today, let me focus on that alleged perfect alignment of interest. Investors like it when hedge fund managers invest substantial assets in their own fund(s). According to the traditional view, this helps to align the interests of the manager with those of the clients. But does it?
Let us look at long-short equity funds as a example. When we regress the appropriate HFRI index on the MSCI World index, we find an estimated beta of about 0.5. Thus, the net average exposure to equities of the typical fund is about fifty percent of the fund’s capital, i.e., only about half of investors’ capital is invested, the rest sits idly in cash. Note that the choice of the net exposure of any fund is completely arbitrary. There is no objective reason why a fund should not be fully invested, on average, or even be levered. But we are told that the typical conservative stance is sensible since the manager’s superior skill will allow her clients to obtain at least the same return as the index over a full cycle but with a much lower volatility. In essence, the managers’ highly positive alpha is supposed to compensate the funds’ much smaller exposure to the equity risk premium leading to a higher Sharpe ratio than an investment in the index.
This argument views hedge funds on a stand alone basis. But for the typical client, the investment in any single hedge fund will be a negligible part of his overall wealth. Thus, the volatility of any one fund is largely irrelevant (as is its Sharpe ratio). What matters is how the fund fits into the overall portfolio. In any case, clients could easily adjust their overall risk budget if a fund moved to a higher net exposure. But there is, of course, one investor who is very much interested in the volatility of the fund: its manager. She often does have much if not all of her liquid assets invested in her fund. Consequently, she will set the net exposure of her fund to a level that is appropriate for her personal risk appetite. She could, of course, keep the fund fully invested, on average, investing only part of her assets in the fund and keeping the rest in cash. But why should she? By having her clients invest alongside her in a fund that is structured to suit her own risk preferences, she manages to extract hedge fund fees on the uninvested part of the fund for what is essentially cash management.
Naturally, there are other explanations for the low average net exposures of many hedge funds. One is that the greater volatility of a fund with higher net exposure might lead to massive redemption in periods of weak performance. There may be some truth to this argument but it is surely much too self-serving to be truly convincing. Another, less flattering, explanation is that it would be easier to assess the performance of a fund that was fully invested, on average. With the current practice of an arbitrary, fluctuating low net exposure, it is rather more difficult to determine what part of the return is skill and what part is not.
Some will argue that successful hedge funds provide ample, relatively stable returns for clients even at low levels of net exposure. But at current interest rates, the traditional two and twenty fee structure – particularly if there is no hurdle rate – leads to unreasonable sharing ratios even for many successful funds. It is obvious that higher net exposure – assuming scalable returns – would allow clients to keep a larger, more reasonable proportion of the gross return of hedge funds.
It is, of course, legitimate for hedge fund managers to run their funds according to their own risk preferences. But the rhetoric of the perfect alignment of interest is obviously quite nonsensical and designed to distract from the fact that low net exposures increase the effective fees charged to clients. Thus, the low net exposure of many funds has all to do with its manager’s self-interest and very little with alignment of interest.
One response to “Perfectly aligned interests?”
I would argue that the fund manager objective is to maximise the NPV of future performance fees. This NPV is significantly more relevant than the performance on her own investment in the fund. Assuming AUM of 50mio and a target return of 10%, the gross profit is 5mio and the performance fee is 1mio. With a discount rate of 10%, the NPV equals 10mio, which is exceed the mere 0.5mio which she has invested in the fund. By maximising the performance fee, she maximise the investors’ performance.
To pursue this exercise, she must focus on her area of expertise:
a. If she only has stock selection capabilities, she should concentrate on pure alpha strategies and maintain a 0% net exposure.
b. If she wants to offer some market exposure with downside protection, she will replicate the exposure of a call option, thus maintain a 50% market exposure (= delta of call option).
I would further argue that a 0% net exposure is the preferred allocation, because investors can gain their target allocation, e.g. 100% in equities, by buying futures and this without paying performance fees.