There is always excitement when a hedge fund initiates an activist campaign against a company’s management to bring about changes. Such funds, called activist funds, play an active approach to investing in stocks by taking large positions and often waging an open battle with the management to force changes. Now a report from Goldman Sachs has found that such activist hedge funds significantly outperformed passive equity hedge funds in the last two years. The Goldman report reviewed data from 778 hedge funds which have $1.8 trillion in gross equity positions among them and found that activist hedge funds generated 40 percent return in the last two years compared to 23 percent by rival passive equity hedge funds.

Investor Activism At 5 year High

The report found that hedge funds played a dominant role in most activist campaigns in the last decade. Between the years 2005 and 2013, hedge funds played lead roles in 64 percent of the activist campaigns. Last year, hedge funds led 75 percent of the activist campaigns. One of the widely followed ongoing activist battles is between the hedge fund manager Bill Ackman, who runs the hedge fund Pershing Square, and nutrient supplement supplying firm Herbalife. Ackman is alleging that Herbalife is a pyramid scheme and is urging regulators to investigate the firm. Ackman holds a large short position on the stock.

The number of activist campaigns has been increasing steadily in the last five years and totaled 129 in 2013, the highest since 2009. The first two months of this year have resulted in 25 campaigns, higher than 22 campaigns in the first two months of 2013. Activist campaigns were red hot in the years 2007 and 2008 when about 155 campaigns were launched in each of those two years. The number plunged to about 70 in 2009 following the Lehman collapse before making a steady recovery in recent years.

Activist Targeted Stocks Outperform in Recent Years

Stocks targeted by activist investors are generally known to make wild moves. The Goldman analysis found that since the year 2010, stocks targeted by activist funds outperformed the Russell 3000 index every year in the immediate three months following the initiation of an activist campaign. The gains were the most in the first month post the campaign announcement. The outperformance of activist-targeted stocks over Russell 3000 was 352 basis points last year in the three months post the announcement. The data also found that such stocks lagged the Russell 3000 in the first three months after a campaign in the years 2007 to 2009.

Impact on Job Market

Launching an activist campaign is often a costly affair. Hedge funds undertaking activist campaigns typically embark on making big changes to a firm. Last year, 34 percent of activist campaigns were aimed at getting board representation and a further 14 percent were to get board control. Most often company management doesn’t give in to the activist funds’ demands easily and hedge funds are required to incur significant expenses to persuade investors to back their efforts.

The data on the number of activist campaigns in the last 10 years suggests that the campaigns increased when the economy and the stock market did well. In an uncertain economy, a fund may be reluctant to commit to a costly proxy war. The steadily increasing activist campaigns in the last few years may point to growing confidence of hedge fund managers about the economy, which could have a positive impact on the job market.

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How much does a chief operating officer of a $5 billion hedge fund, who does not make stock picking decisions, make when the fund generates a 10 percent return? The answer is $10M – according to findings from a survey by executive search firm Boyden. The survey finds that with the compensation structure at hedge funds, even those positions which have nothing to do with a hedge funds’ investments, such as chief operating officer, have an incentive bonus clause that offers significant bonuses when the funds generate positive returns.

Compensation Structure

A hedge fund typically has a person overseeing the operations of the firm. The position holds different titles such as CEO, president or chief operating officer but the responsibility is one of ensuring the smooth running of the firm to enable the fund manager(s) to focus on research and investments.

The Boyden research finds that a chief operating officer in a typical hedge fund has a compensation structure that has three parts. One is a base component which ranges from $500,000 to $1 million in a hedge fund managing $5 billion in assets.

Chief operating officers also enjoy a fixed bonus irrespective of whether the fund generates anticipated returns in a year. This fixed bonus component is based on the management fee charged to investors on the assets managed by the firm. The research finds that a chief operating officer makes roughly $1 million to $2 million in fixed bonus on assets of $5 billion.

The third and last component is an incentive bonus paid when funds generate positive returns. According to the survey, incentive bonuses generally have no caps but a 10 percent return by a $5 billion hedge fund would net an operating officer around $5 to $10 million.

It is worth noting that hedge funds across all categories returned 9.3 percent in 2013, according to data published by HFR Research, suggesting that even in an underperforming year, hedge fund executives could pocket big money.

Deferred Compensation an Emerging Trend

The survey found that hedge fund investors are pushing for deferred compensation and other performance-based incentives to be a large component of a CEO’s compensation. While it is common for a fund manager to have a pay structure with a large percentage tied to performance, until recently operating officers at hedge funds had much of their compensation as fixed components. Commenting on this evolving trend, Kate Quinn a partner at Boyden says this trend toward performance-based incentives will make old school executives uncomfortable but adds that this is a trend that will likely stay.

The findings from the survey brings to attention the leverage that hedge fund investors currently have to force changes to the fee structure within a fund. For job seekers, this evolving trend may send mixed signals. The role of operating officers in hedge funds has become critical. A chief operating officer is responsible for the funds’ compliance with all regulatory reporting requirements. As such, the role cannot be compromised and it is likely that hedge funds would twist the compensation structure to strike a balance that is appropriate to maintain high level of motivation among its operation managers, and at the same time, satisfy investor demands.

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Hedge Funds Targeting Risky Real Estate Lending

March 10, 2014

One of the reasons that investors commit to pay high management fees to hedge funds is the agility of hedge funds to adapt to developing opportunities. One such investment opportunity that is currently attracting hedge funds is commercial real estate debt. Lured by the potential to earn returns as high as 15 percent, hedge funds […]

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US Hedge Funds Hire for Eurozone Distressed Assets

February 24, 2014

US hedge funds are looking to take advantage of new stringent capital rules on European banks to buy discounted asset-backed securities and bad loans from European banks. Bloomberg reports that hedge funds are competing with private equities for discounted assets in Europe and are hiring staff as well as relocating executives in hopes of finding […]

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Hedge Funds Suffer Biggest Net Outflow Since 2009

February 10, 2014

Investor redemptions at hedge funds hit the highest level in December in more than four years according to the SS&C GlobeOp Capital Movement Index which tracks the monthly hedge fund subscriptions and redemptions. For December, the index showed a negative reading of 3.56 percent, the biggest negative reading since September 2009. While high end of […]

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Hedge Funds May Lose Lead to Exchange Funds in 2014

January 27, 2014

The hedge fund industry is in danger of falling behind exchange traded funds in total investments for the first time in 2014 if current trends persist. Unlike hedge funds, exchange traded funds are passively managed and track a commodity, index or a basket of assets like an index fund. A major attraction for investors in […]

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Hedge Fund Compensation 2014 Data

January 14, 2014

Back in 2011, those in hedge funds discussed how the weak market was quickening the redemption rate and causing a difficult job market for alternative investment professionals. This was in addition to were worried due to a decrease in fund performance and corresponding But these days, the news is mostly good. The market is up […]

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