One of life’s certainties is that, over a sufficiently long time horizon, your investment manager will become richer than you. John Kay reached this conclusion in an excellent recent column for the Financial Times, in which he explained the effects of applying compound interest to investment management fees. Using the example of Berkshire Hathaway, Mr Kay explained that if, over his 42-year career, Warren Buffet had charged the hedge fund industry standard 2 per cent management fee plus 20 per cent performance fee, of the $62bn (£31bn, €39bn) of wealth he had created, as investment manager he would have kept $57bn.

Martin Wolf, meanwhile, also writing in the Financial Times, recently argued that incentive structures of this sort encourage unscrupulous hedge fund managers to invest in strategies with a high probability of a modest gain and a low probability of huge losses in any period. Eventually, the low probability disastrous event will occur, but by then the manager has grown fat on his 2/20 rewards and no system of clawbacks exists for the repayment of losses. Hedge funds, essentially, are a scam.

Mr Wolf makes some good points, not least that it is hard to distinguish between talented and untalented managers. Indeed in recent years this problem may have become worse. The credit crisis has revealed that, during the bull market that preceded it, many managers were not generating true alpha. Instead they were taking advantage of exposure to “alternative betas”, such as the premia earned for the illiquidity of certain assets, which were underpriced in the frantic search for yield. Investors should be wary of any manager touting a strong track record for 2002-06, who explains away losses in 2007 as “unavoidable” because of the wider market malaise.

It is also hard to argue with Mr Kay and Mr Wolf that the 2/20 fee model distributes a disproportionate share of the spoils to the investment manager. But this unequal distribution of returns need not imply a misalignment of interests between managers and investors. After all, hedge fund managers typically have their own capital invested in their funds.

One of the most surprising things about the hedge fund fee structure is how durable it has proved, despite an estimated 8,000 funds to choose from globally. In fact, with access to the best fund managers often a problem, investors effectively compete with one another to pay away alpha. The rationale behind this probably comes back to compound interest – if you must live on crumbs from the manager’s table, it is better that they are large ones rather than small ones, since the former will benefit more from compounding. Still, given that hedge fund returns, in aggregate, have become less exceptional over time, downward pressure on fees for the “average” hedge fund manager appears inevitable.

A distinction should also be drawn between investment behaviour and the vehicle in which it is practised. It would be naive to suggest unscrupulous and imprudent investment behaviour does not exist. But recent experience shows that the worst behaviour is not confined to the hedge fund industry. One of the earliest high-profile casualties of the credit crunch was Northern Rock, a UK mortgage bank that was guilty of expanding its loan book too rapidly while attempting to fund it predominantly in the short-term money markets. Société Générale and Credit Suisse have both owned up to frauds perpetrated by their own traders and Bear Stearns has paid the ultimate price for its exposure to mortgage-backed securities.

Banks that have escaped with multi-billion dollar writedowns are not blameless either. A good part of the responsibility for the current market turmoil can be pinned on the shift within the banking industry from direct lending to an “originate and distribute” model.

By moving credit risk off their balance sheets, banks had a vested interest in writing as much new business as possible to generate fees. Greed is not solely an attribute of the beneficiaries of 2/20 fee structures.

The intervention of governments and central banks to help resolve the current crisis with public money may well lead to greater regulation of financial institutions. But greed cannot be regulated away entirely.

Recurrent crises have been a feature of financial markets for centuries and there is no reason to believe that the latest example will be the last.

This suggests that anyone investing over a long period of time must contend with periodic sharp setbacks.

Investment vehicles that seek to generate absolute returns in all market conditions, rather than merely beat their peer group, have a place in a portfolio designed to minimise those setbacks. The problem with hedge funds is their high fee structure, not their investment rationale.

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