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August 21, 2006 7:59 pm

James Altucher: A thriving juggernaut that is getting too greedy

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I hate to say it but most hedge funds should be charging 50 basis points as a management fee and 0 per cent as a performance fee right now.

And most people who are invested in hedge funds should pull their money out. I don’t mean to be a “player-hater”. Heck, if you want to pay a 20 per cent performance fee (and Lord knows I’m paying it in quite a few cases), then go right ahead. There are plenty of people lined up to take your money while doing no work for it.

I’m being cruel but I’m not worried about hurting anyone’s feelings. The hedge fund industry is a thriving juggernaut that couldn’t care less, as a whole, about this little column here. The industry has sucked all the manpower out of every other crevice and hole in Manhattan and many other cities as well. But I do feel a little sorry for all the junior analysts doing the reverse commute out to Greenwich just in time to watch the Great India Outsourcing of 2008 occur.

That will happen when everyone realises that we might as well ship our research and quantitative needs to the PhDs in Calcutta who will do it for $8.50 an hour. And I know this because I do it. More on that in a later column.

But back to the topic here. Why should fees be less? There are structural reasons and then there are practical reasons. The structural reasons include the fact that the S&P, the Dow Jones, and about a dozen other institutions, now have hedge fund indices to keep track of all the moves of their favourite arbitrage strategies. This “death by indexing” has resulted in a trillion dollars being flushed down the toilet at the hottest funds, only to watch returns now go essentially to zero, with Treasury bills returning 5 per cent.

The practical reasons are that most – if not all – hedge fund strategies can be simulated using publicly available exchange-traded funds or other techniques that avoid the fees hedge fund managers charge.

Let’s face it, my heroes are the cowboys who raised $50m, $100m and then, miraculously, $1bn back in the 1970s, 80s and early 90s – people such as George Soros, Julian Robertson, Stevie Cohen and Michael Steinhardt.

No pension fund manager would risk his job putting money with these guys. They were cowboys, riding roughshod over the English pound, shorting bonds with impunity in the 1980s, tearing apart their weaker brethren in the back-to-back events of the 1997 Asian currency crisis and the 1998 collapse of Long-Term Capital Management. They knew just when to dump their initial public offering allocations in the late 1990s and when to hang up the hat, with billions in the bank, when the going wasn’t as good.

Mr Cohen and Mr Soros are still at it but for them it’s a game at such an esoteric level, having little to do with providing food, shelter and protection of family, that it is no longer the same. And that game is over. Hedge funds are institutions, in the same way as the bank where you deposit your pay cheque and earn 1 per cent interest in a money market fund.

The anomalies and arbitrage situations these funds earned their keep on don’t really exist any more.

Which have been the outperforming hedge funds in the past few years? Answer: the guys specialising in microcaps, energy and emerging markets. But that’s only because those markets have drastically outperformed the broader markets since 2003. There’s no way to tell if there’s been any real “alpha” obtained by any of these funds in this period, and the best way to tell is to look at all the funds that have dropped into the negative corner since May – since emerging markets and microcaps have flushed.

And what is the future? Convertible arbitrage can’t go anywhere with spreads at zero. The only way they widen is if defaults go crazy and/or the Federal Reserve cuts rates. Merger arbitrage is directly correlated to a strategy of selling puts against the S&P 500. So don’t bother to pay the hedge funds their fees – sell puts. Better yet, save your money and put it in Treasury bills because with volatility so low, the selling puts (or merger arbitrage) strategy holds more risk than gain.

Market neutral is like rolling the dice now, as previously correlated pairs dance randomly around one another while a trillion dollars worth of arbitrage tries to figure out when the music will stop. But I do like the investments where the fund managers directly touch their investment – private investments in public equity (PIPEs), asset-backed lending and activism – since the manager is more involved in unlocking value. When he touches the investment he knows that is an edge his 10,000 competitors don’t have.

But for the rest, it’s nothing more than traditional wealth management with a twist. The joke in the hedge fund industry is that most people don’t get that. The going rate in wealth management is about 50 basis points, give or take expenses.

james@formulacapital.com

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