The Good, Bad, and Ugly in Hedge Funds: A Manager's View

BusinessWeek reader and hedge fund manager Eric Jackson considers the pros and cons of his industry

By Eric Jackson

Naples (Fla.)-based BusinessWeek reader Eric Jackson is founder and managing member of Ironfire Capital LLC and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund Ltd.

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Not too long ago, practically every newly minted MBA wanted to be a hedge fund manager, and investors—including many conservative pension funds and endowments—rushed at the chance to place assets in hedge funds. Yet hedge fund managers were blamed for both artificially inflating the price of oil last summer and, when prices dropped, for contributing to the looming recession.

The mainstream press has now taken to derisively calling them "former masters of the universe," while noting that compensation is still "obscene." As quickly as assets came in during the up market, they have gone out in a declining market. In the last quarter of 2008, $152 billion in hedge fund assets were redeemed, even ones with positive returns in 2008.

As a hedge fund manager, I'm neither an apologist nor a cheerleader for my industry. Like any business, the hedge fund world has good and bad practices and managers. All managers need to accept accountability for the trying times we are living through. But it's fanciful to suggest hedge funds are about to disappear. Quite the opposite: The industry will be thriving even five years from now because it will continue to attract the best managers and the most sophisticated investors seeking alpha through innovative strategies. Here are some of the good and bad practices in the industry today:

Barbarians at the Gates

Hedge funds have long had "gates" as options available to the fund and/or manager included in their subscription documents. All investors reviewed these prior to making an investment. You haven't heard much about them because hedge funds haven't gone through a sustained down period the way we have in the past six months. As a result, a number of funds have exercised their rights to enforce a gate, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.

Gates are a perfectly legitimate operating mechanism and will continue to be part of hedge fund investing. Moreover, as so many funds have decided to use them in the past four months, it is unlikely any one fund will be unfairly penalized by investors when they raise new funds down the road. The managers who will be penalized for putting up a gate are the ones who continue to charge fees after doing so. That's their right under their agreements, but it certainly doesn't engender goodwill, and investors tend to have elephant-like memories.

Overpaid and Underperforming?

Critics have attacked the standard hedge fund compensation model of 2% annual management fee and 20%-of-profits performance fee in light of the industry's poor 2008 performance (-19.2% for the average fund, according to Hennessee Group). Yes, many hedge fund managers made bad calls in 2008, but one-third of hedge funds made money in a year when the Standard & Poor's 500-stock index was down 40%. Only 1 in 1,700 mutual funds made money in the same period, meaning you were 50 times more likely to make money in a hedge fund compared to a mutual fund last year. What is that worth in fees?

Sadly, some hedge fund managers don't help themselves in the court of public opinion. Call it John Thain-itis. Many media profiles of hedge fund managers mention private jets, homes in the Hamptons, and flashy lifestyles, none of which has any predictive value about whether a hedge fund is a good investment. It's always been about the returns over a specific period of time, and the comparable risk-reward of other alternatives to invest their money.

Eyeing High-Water Marks

Hedge funds typically have high-water marks, which require hedge fund managers to make their investors whole before paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years.

What high-water marks also do—from an investor's perspective—is level the differences between a hedge fund and a mutual fund or other asset manager. Any investor has to pay a percentage of assets in management fees to a money manager. In the case of hedge funds, an investor pays performance fees only when the manager makes money. Investors also know that hedge funds will invariably attract more talent because the compensation levels are higher than the mutual fund industry or elsewhere.

Some observers feel that high-water marks are not the panacea they seem. In a down year, they argue, you can just shut down your fund to avoid the pain of making back past losses and open up another shop across the street. Although this can and does happen, it's just as common for hedge funds to honor their high-water marks instead of taking the easy way out and shutting down, eliminating the high-water mark, and reopening later.

Bottom line: If managers screw up, they need to face the consequences. It's that kind of Darwinism which makes the industry strong. Investors shouldn't have any qualms about having to pay performance—or more correctly stated, revenue-sharing—fees.

Reconciling Differences

With over 10,000 hedge funds worldwide in 2008, funds naturally vary in size and strategy. Some pursue absolute returns, always seeking to grow capital, no matter the market; others aim to beat the S&P or other benchmark on a relative basis. Absolute and relative performance strategies have different levels of volatility due to the different types of risk they take on.

James Simons of Renaissance Technologies recently announced that his firm would not charge fees to existing investors for its Institutional Futures fund, which was down 12% in 2008, but would still charge fees on its Institutional Equities fund, which was down 16%. The difference between the two funds? The first follows an absolute return strategy, while the second aims to beat the S&P 500 by 4% to 6%, which it did.

There is no question that there's a sea change taking place in the hedge fund industry, which saw its assets decline by $782 billion, to $1.21 trillion, in the past year. That's a Detroit-like drop in demand on a year-over-year basis. Within five years, it's likely the mega-funds will dominate, similar to the private equity world, where you have KKR, Bain, T.H. Lee, and a lot of small fry.