Hedge fund models to evolve - Madoff Fraud - Impact on Hedge Fund Business

As hedge fund returns continue to disappoint, there has been a cacophony of voices calling for changes in approach to investment in hedge funds and for reform in the industry. Some are pure marketing hype, while others do have some value. Here are a couple of notable examples (and my reactions):

Hedge funds as alternative beta instruments
Lars Jaeger suggested that investors should view hedge funds as sources of alternative beta, which I take to mean that they are diversifying. He went on to indicate that investors should take a macroeconomic based approach to managing these hedge fund betas as a way of adding alpha to the overall portfolio.

I blogged some time ago that a Bridgewater study showed that hedge fund strategies have definite return patterns. For example, emerging market hedge fund returns could largely be replicated by a portfolio of 50% emerging market stocks and 50% emerging market bonds. If hedge fund strategies have betas, why not structure their incentive fee to their passive benchmark? In the case of an emerging market hedge fund, pay 20% of the outperformance against a 50/50 emerging market stock/bond benchmark, rather than an absolute return benchmark?

Longer lockups and different incentive structure
Another suggestion is for a longer lockup but the incentive fee doesn’t get paid out until the end of the lockup. In this case, there is a three year lockup in the fund, but the incentive fee doesn’t get calculated and paid out until the end of the three years.

I think that this is a good idea. It takes away some of the short term-ism that exists among hedge fund managers. Having worked at a fund with quarterly incentive payouts, I personally experienced the mentality that there are only four important dates in the year – the quarter end dates.

Heads I win, tails I walk away
One of the problems with the hedge fund industry is the asymmetric nature of the return incentives. Heads I win. Tails I walk away. If the fund return suffers and the unit value falls significantly below the high-water mark, the manager’s incentive to run the fund diminishes. The temptation to close the fund, walk away and start afresh grows as the fund returns get more negative.

Here are my suggestions for structuring a hedge fund in a way that is fair to the investor:

Benchmark: Benchmark the fund’s returns to the strategy proxy (see above example of the emerging market fund). When I moved from the long-only asset management world to the hedge fund world, I was shocked to see that there was a recognition that different strategies had return betas but incentive fees were not calculated in excess of the beta of the fund. Intermediaries were already pigeonholing hedge funds into different strategy groups (e.g. convertible arbitrage, global macro, etc.), so that was not a problem. Why are investors paying alpha fees for beta?

If a fund can truly demonstrate that it has an undiversified alpha that is uncorrelated to any of the other hedge fund strategy benchmarks, then do you structure the incentive fee to a cash benchmark.

Incentive fees: Make the manager truly eat their own cooking. Instead of paying an incentive fee in cash, pay it in units of the fund, with a lockup. For example, a fund could pay an incentive fee of 20% of a return in excess of a benchmark. The manager would then be required to reinvest the incentive fee back into the fund, with a three-year lockup. That way, the manager would have strong incentives for risk control and blowups would hurt his own wallet a lot more.

Additionally, the fund could be structured with a longer lockup with an incentive fee payout at the end of the lockup.

People respond to incentives
The problem so far has been the incentives in the financial markets have been wrongly structured. A lot of people made a lot of money without adding a lot of value, or added value short-term by increasing risk longer term. I have suggested before that making the reward system symmetric in investment banks could solve a lot of the structural problems on Wall Street.

We can use the same approach to fix the hedge fund industry too.