Hedge Fund Math

Hedge Fund Math

sexy-mathHedge I Win Tales You Loose!  Besides Performance We Charge the Management fee!

 

How well do all these hedge-fund managers do?
Great!
Because the hedge-fund business is the best business in the world. Unless you’re a client.

All Together Hedge Fund Profits Near Zero

The first graph below shows the portion of hedge fund profits that go to the hedge funds, the fund-of-funds, and the investors, using total dollars from 1998-2010. This is from Simon Lack’s presentation, which is derived from his book Hedge Fund Mirage. Notice 97% go to insiders, 3% to investors.

Like most strategies or asset classes, the money made on a percent basis is large because it basically grows until it can’t work, at which point it loses more money than it made and then some more (see above graph, 2008 killed everything). It could be thought of as an endogenous reaction, because how else will you know at what point it stops working? Perhaps this is the essence of all financial cycles.

Hedge Fund managers inevitably argue they do not fit into clean categories; that they, unlike everyone else, is neither fish nor fowl. I suppose we all think we are unique, and don’t like to be benchmarked, but on the other hand, everyone is riskier without a benchmark.

 

funnyHeads we win, Tails you loose!

For example, let’s consider a hypothetical hedge fund called Capital Compensation Partners, LLC.
Let’s assume the firm raised a $1 billion fund at the end of 2002 with a typical 2/20 fee structure: 2% annual “management” fee and 20% of any “performance.” Let’s say the fund manager invested the entire fund in an S&P 500 index fund on Jan 1, 2003.
Here’s how the hedge fund would have done over the next six years:

2003 Performance: +25%
Client Assets At Year End (less fees): $1,185,000 (+$185 million)
Total Fees: $65 million

2004 Performance: +10%
Client Assets At Year End (less fees): $1,257,000 (+$72 million)
Total Fees: $46 million

2005 Performance: +2%
Client Assets At Year End (less fees): $1,253,000 (-$4 million)
Total Fees: $30 million

2006 Performance: +14%
Client Assets At Year End (less fees): $1,370,000 (-$117 million)
Total Fees: $58 million

2007 Performance: +4%
Client Assets At Year End (less fees): $1,389,000 (-$19 million)
Total Fees: $36 million

2008* Performance: -39%
Client Assets At Year End (less fees): $820,000 (-$569 million)
Total Fees: $27 million

Total Hedge Fund Fees Over 6 Years: $261 million
Total Client Performance Over 6 Years: -$180 million

To summarize: Over the six years Capital Compensation Partners was in business, the firm made about $250 million, and the firm’s clients lost about $200 million. All the risk, meanwhile, was borne by the clients, who got obliterated in the end.
It’s no secret that hedge fund managers are a super-smart lot.

And what’s the best thing that happen? Well, John Paulson’s $3.7 billion compensation in 2007 is a reasonable benchmark for hedge-fund managers to shoot at.
Wait, John Paulson? Isn’t he the guy who incinerated about half of his clients’ money last year?
Why yes he is!
Because past performance is no guarantee of future results. Except with respect to fees.

Of course, most hedge fund managers are neither failures nor John Paulsons–they’re just somewhere in the middle. They do pretty well in years in which the markets are going up, and they get clobbered when they’re going down.

How well do these hedge-fund managers do?
Great!
Because the hedge-fund business is the best business in the world. Unless you’re a client.

What is Hedge Fund?

 

2013-07-12T09:41:08+00:00

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