‘Mr Ten Per Cent’ has long been a term of contempt. Indeed, finagling Hollywood agents’ decimation of their clients’ earnings resulted in one of the few successful exports of a Spoonerism to California — to explain the difference between a talent agent and a rooster (the latter ‘clucks defiance’). So why has it taken a global credit crisis, the collapse of several major investment banks, and Bernard Madoff’s alleged £50 billion fraud, for anyone to question the remuneration of the agent’s Wall Street equivalent: ‘Mr Twenty Per Cent’? Or, to use the full, double- barrelled monicker more befitting his Mayfair cousin: ‘Mr Two-and-Twenty’?
He is, of course, the hedge fund manager, who has been charging clients 2 per cent of assets under management plus 20 per cent of profits ever since Alfred Winslow-Jones, the father of the hedge fund industry, first had the chutzpah to introduce this fee structure on an absolute-return fund back in 1949.
Sixty years later, the performance of hedge funds that were supposed to buck, or at least neutralise, the market has been absolutely dismal. According to Hedge Fund Research, the average fund ended 2008 down more than 18 per cent. Both fixed-income and equity strategies failed — despite the strong performance of conventional bond funds and the obvious short-selling opportunities. ‘Convertible bond arbitrage’ funds were down 33.6 per cent, while ‘quantitative directional’ funds lost 22.9 per cent. Arguably worst of all, however, were the ‘funds of hedge funds’. Not for their 20.9 per cent fall — only 0.5 per cent of which can be attributed to Madoff exposure — but because they claimed an ability to outperform the wider hedge-fund universe through skilful fund selection. And they charged, for their trouble, an additional ‘1 and 10’, on top of the underlying ‘2 and 20’.
It’s not difficult to see why they tried it on. Jonathan Ford, writing in the Financial Times last year, suggested the following reductio ad absurdum. Imagine that two hedge fund managers raise equal-sized funds of $500 million. Instead of investing the money to produce returns for their clients in the normal way, they agree their annual investment outcome on a single flip of a coin, with the loser giving the winner 50 per cent of his fund. At the end of the year, one of the hedge funds would have $750 million and the other $250 million. But they both earn ‘2 and 20’. They each make $10 million as their 2 per cent fee — and the winner pockets a further 20 per cent on his apparent $250 million profit. So the hedge fund managers collect $70 million between them, while the average return to clients is a negative 7 per cent.
Absurd it may be, but consider the observation of Merrill Lynch’s John Millar on hedge funds in April 2007, just before the credit crunch took hold: ‘So long as “2 and 20” continues and costs remain reasonable, they are fabulous businesses with impressive cash flows.’
What’s harder to fathom is why institutions, private banks and wealthy individuals agreed to pay an extra layer of charges for $685 billion worth of fund-of-hedge-fund investments. It seems that the managers succeeded in suspending not only disbelief, but also the laws of economics and natural selection. Holding illiquid assets in opaque structures made relative performance impossible to judge — an environment in which competition did not generate downward pressure on fees. Excluding extinct funds from the indices made survivors appear fitter than they really were — and their managers worth paying for.
Giving their funds names like ‘Fortress’ and ‘Citadel’ may have earned investors’ approval, too — although investors in Madoff’s ‘Defender’ fund may now consider the suffix ‘-ant’ more appropriate.
A comparison with the most successful conventional fund in history demonstrates the extent of the folly. Economist John Kay, in his new book The Long and the Short of It, imagines what would have happened if Warren Buffett had paid a hedge fund manager to run his Berkshire Hathaway investment vehicle. Over 42 years, Berkshire Hathaway earned a compound annual return — for all its investors — of 20 per cent, of which Buffett’s share was £62 billion. But if he had hired Mr Two-and-Twenty, and let him re-invest all his fees, the manager would have ended up with $57 billion, leaving Buffett with just £5 billion to get by on.
By Kay’s calculation, ‘2 and 20’ reduces a 10 per cent return to 6 per cent over the long term. For private investors, who can only access hedge funds via funds of funds, that 10 per cent shrinks to 3.5 per cent. As Kay puts it (in homage to Fred Schwed Jr’s classic 1940 exposé of Wall Street, Where Are the Customers’ Yachts?): ‘That sum tells you why it was the giants of the financial services industry, not the customers, who owned the yachts.’
However, with the tide now out, some yacht captains are leading the mutiny. In recent months, Sir John Craven, former chairman of Deutsche Morgan Grenfell, has accused funds of hedge funds of ‘daylight robbery’. Dan Fuss, the 74-year-old vice-chairman of Boston-based Loomis Sayles has blamed ‘2 and 20’ for encouraging the irresponsible borrowing that fuelled the credit crisis.
And Nick Greenwood of Midas Capital has predicted that few London-listed funds of hedge funds will be left by the end of this year. Some — including Close Man Hedge and F&C Event Driven — have already announced an intention to wind up.
Ironically, this now suggests a genuine investment opportunity. Last year, Marshall Wace gave investors in its £754 million MW Tops hedge fund the chance to get out at close to net asset value, after its share price had fallen to a 23 per cent discount to those assets. So, with London-listed funds of hedge funds trading on even greater discounts, buying into a fund that winds up in 2009 could deliver an near-instant return of up to 40 per cent.
But don’t pity the managers. Many are still clucking defiance by launching new hedge funds to buy up distressed assets — and charging ‘1.5 and 15’.
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