This column was originally published on RealMoney on Dec. 21 at 3:00 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
Writing in a
column about what he sees as an unsustainably low valuation for a French telecom stock, money manager Ken Fisher wrote, "Crazy happens in France." I believe crazy happens in the U.S. financial markets, too.
Among other things, I think it is crazy that more than 9,000 hedge funds are in existence. Hedge funds are the highest-cost legal investment option in the free world. The expenses that hedge fund investors bear put variable annuities, front- and back-loaded mutual funds and broker-wrap accounts to shame. The typical fund carries an annual expense ratio of 2%, plus a percentage of the profits on the order of 20% or more.
Taken alone, high expenses should not be a deterrent to investing in the best hedge funds. I'm in favor of paying top dollar for consistently tremendous performance produced by certain elite hedge fund managers such as George Soros, Michael Steinhardt, Ed Lampert and Steven Cohen.
Let's be generous and classify the entire top decile of hedge fund managers as geniuses. That would imply that roughly 900 bona fide superstars are now operating hedge funds. (If you're smart and wealthy enough to hire one of them to manage part of your portfolio, allocating some capital to them may make sense. But you'd better be lucky, too, because many of the best managers' funds are closed to new investors.)
So if you agree with the rather generous notion that about 900 hedge fund managers are geniuses of capital allocation who deserve enormous fees, that leaves more than 8,000 mere mortals operating hedge funds. Almost all of these funds operate under fee structures that are similar to those of the superstars, and a good number of them are simply leveraged risk pools (beta machines), not traditional hedged vehicles. As such, they could hit a mind-blowing home run (see T. Boone Pickens), but they could also blow up and go to near zero (see Amaranth).
This situation is crazy. It's as if a major-league baseball team decided to pay every player on its roster the same salary as Alex Rodriguez. (Wait a second. The Yankees might actually be trying to do this!) The fact that the team owner may be able to afford the enormous cost is beside the point; it would still be irrational. But this is exactly what most hedge fund investors are doing. They are overpaying, to the tune of billions upon billions of dollars, for investment services. And lots of hedge fund managers, fund-of-funds and prime brokers are laughing all the way to the bank.
Most wealthy and institutional investors who invest in hedge funds would be much better off in a mix of bond accounts and passive or actively managed long-only equity. If you're concerned about downside volatility (no rational person worries about upside volatility), you could inexpensively hedge your long assets with a variety of tools, including options strategies, shorting indices on a ratio or even some of the newly developed inverse ETF products. The all-in cost of all of these strategies would be much lower than just about any hedge fund product that is available.
In fact, many hedge fund investors would even be better off allocating their capital to actively managed mutual funds. This is a sacrilegious statement in the hedge fund community, which generally castigates long-only investment managers. But, to use one example, Bill Miller might be the best money manager alive right now. If you hire him to manage a portion of your money in his
Legg Mason Value, you'll pay under 2% per year in expenses for the privilege -- and you'll keep all of your after-tax profits. That might be a smart move for the cost-conscious investor. But paying more than 2% per year and more than 20% of the profits to most hedge fund managers? Crazy.
Crazy situations occasionally crop up in the financial markets, but they are always arbitraged out by market forces in the long term. Accordingly, I expect 2007 to be the year in which the worm turns for the hedge fund world. It might end with a bang -- with the implosion of a large, well-respected fund. Or it might end with a series of whimpers as investors begin to get wise to the fact that it's silly to pay premium prices for mediocre performance and/or dressed-up beta machines.
Either way, I expect sometime in 2007 to see
reporters chasing some unlucky hedge fund manager down Park Avenue, asking him to explain the disparity between his pay package and the returns of his funds' investors. With an increasing pool of pension fund money being thrown into hedge funds, I expect this scene to include a montage comparing the manager's Croesian lifestyle with the financial situation of the poor retiree whose retirement was invested in a failed hedge fund through his pension plan. As our own Doug Kass (an esteemed hedge fund veteran himself) likes to say, "Sic transit gloria."
There's more crazy ahead, too. Check back for Part 2 of this column.
At time of publication, Conley had no positions in any of the stocks mentioned in this column, although holdings can change at any time.
Norm Conley is president and chief investment officer of JAG Advisors, a St. Louis-based money-management firm. As co-manager of JAG's Large Cap Growth separate account product, with more than $175 million in assets, he's a long-only investor who focuses on growth companies with favorable fundamental and technical characteristics. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Conley appreciates your feedback;
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