Hedge Funds: The Road Back

Sadly, some hedge fund managers don't help themselves in the court of public opinion -- call it John Thain-itis. Most profiles of hedge fund managers include references to private jets, homes in the Hamptons, and flashy lifestyles. Discussions about managers giving to the Robin Hood Foundation are less common. A fund-of-hedge-fund manager recently told The Wall Street Journal: "I was definitely overpaid in the good times and now I'm definitely being underpaid in the bad times."

Those comments don't put anyone in the industry in a good light (especially that manager) but, at the end of the day, these comments or whether some manager buys a flashy car, has no predictive value on whether a hedge fund is a good investment. The truth is that hedge fund managers basically will only survive as a firm if they perform. If not, they'll be out of business (as many will in the next six months) and going into a different industry.

Most investors I know don't mind paying fees, as long as they get acceptable performance. When they don't, they redeem -- as they are in spades at the moment in the industry.

Don't Tinker With High-Water Marks

Hedge funds typically have high-water marks, which require managers to make their investors whole before resuming paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years. Ken Griffin of Citadel, which dropped 55% in 2008, said recently that he and others at his shop would only be working for "psychic income" for the next few years, as they crawl out of their negative performance hole.

Some critics have said that high-water marks are not the panacea they seem. If you have a down year, these critics say, you can just shut down your fund to avoid the pain of making back past losses and open another shop up across the street. Although this can and does happen, it's equally 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 re-opening later.